Income Tax Appellate Tribunal - Delhi
Motorola Solutions India Pvt. Ltd., ... vs Assessee on 14 August, 2014
IN THE INCOME TAX APPELLATE TRIBUNAL
DELHI BENCH 'I': NEW DELHI
BEFORE SHRI S.V. MEHROTRA, ACCOUNTANT MEMBER
AND
SMT. DIVA SINGH, JUDICIAL MEMBER
ITA No. 5637/Del/2011
Assessment Year: 2007-08
M/s Motorola Solutions ACIT,
India Private Limited, Circle-2, 4th Floor, Vanijya
Mehrauli Gurgaon Vs. Kunj, HSIIDC Bldg., Udyog
Road, Vihar,
Gurgaon. Phase-V,
PAN NO. Nr. Shankar Chowk,
AAACM9343D N.H-8.
Gurgaon.
(Appellant) (Respondent)
Appellant by: Sh. Himanshu Shekhar Sinha, Adv., Sh. Ankit Arora, CA, Ms.
Somya Seth, CA
Respondent by: Sh. Peeyush Jain, CIT/DR (T.P)
ORDER
PER S.V. MEHROTRA, A.M.
This appeal filed by the assessee is directed against the order of ld. CIT(A)- , Gurgaon, dated 31/10/2011 for A.Y. 2007-08.
BUSINESS PROFILE OF ASSESSEE:-
2. The assessee, a Motorola Group company, is a leading supplier of mobile phones and equipments for mobile broadband and automobile networks. The company was originally founded as galvanizing manufacturing corporation in 1928, with the first product being the battery eliminator.
2.1 The business description of group, as mentioned in TP report, is as under: ITA No. 5637/D/2011 2
1) Motorola Inc. (Group Companies): Motorola Inc. is a company headquartered in Schaumburg, USA, however, its group companies are spread across the world. The main areas of operations of the Motorola Group are broadly structured around Wireless, Broadband and Automotive Solutions.
Motorola is operationally structured in the following segments:
a) Connected Home Solution;
Motorola's Connected Home Solutions (CHS) business is focused around broadband solutions for the delivery of voice, video and data over HFC Networks. CHS core business revolves around the delivery of digital audio and video interactive applications, internet access and high speed data.
b) Government & Enterprise Mobility Solutions;
This segment is a provider of integrated radio communications and information solutions, with a focus on Government and enterprise customers worldwide. It also designs, manufactures and sells automotive and industrial electronics systems and telematics systems that enable automated roadside assistance, navigations and advance safety features for automobiles.
c) Mobile Devices;
This segment designs, manufactures, sells and services wireless subscription and server equipment for cellular systems and iDRN integrated digital and enhanced networks, advanced messaging devices, personal two way radios and a broad range of mobile data services, servers and software solutions, portable energy storage products and systems, servers and software solutions and related software and accessories products.
d) Networks;
Motorola is engaged in the design, manufacture and sale of end to end CDMA and GSM wireless communications system.
e) Integrated Electronic Systems Sector;
ITA No. 5637/D/2011 3This segment design, manufactures and sells automotive and industrial electronics systems, telematics systems that enable automated roadside assistance, navigation and advanced safety features for automobiles, portable energy storage products and systems embedded computing systems. 1.1 Motorola India Pvt. Ltd. (MIPL)- The assessee, Motorola India Pvt. Ltd., was incorporated in 1989. Its majority shares are held by Motorola International Credit Corporation, USA (MICC), which is in turn, wholly owned subsidiary of MINC. Motorola India is primarily engaged in the distribution of tele-current equipment, mobile phones and provision of tele-communication service in India. The company also provides software development services to the group companies. Additionally, the company also provides marketing and administrative support services to its group companies. 1.2 Shareholding Pattern:
Motorola Motorola Winphoria Force
Inc. International Inc. Comp Inc.
(MNC) Credit Corp. (WINC) (FINC)
USA
30% 65% 3% 1%
Motorola India Pvt. Ltd.
(MIPL)
1.3 MIPL's Headquarter is at Gurgaon with sales offices at Delhi, Mumbai and Bangalore. It operates its software development centre at Bangalore & Hyderabad.
ITA No. 5637/D/2011 4ISSUES:-
3. The assessee e-filed its return of income declaring loss of Rs.
8,82,63,570/-. The AO noticed that assessee had undertaken following major international transactions with its Associate Enterprise (AE) during the F.Y. 2006-07:
a.Provision of software development services Rs.6,812,082,673/- b.Provision of administrative and market support services Rs.759645791/- c.Distribution of telecom equipments and handsets Rs.22,271,592,925/- d.Reimbursement of expenses from group companies Rs.9,10,352/-. 3.1 The AO, accordingly, referred the matter to Transfer Pricing Officer (TPO) u/s 92CA(1) for determination of the arm's length price of the international transactions undertaken by assessee. The TPO vide his order dated 28thn October, 2010, determined the arm's length price of the aforementioned transactions and corresponding adjustments to be made to the declared prices, as under:
Nature of ALP Adjustment
International
Transaction
Software 7,883,525,000 107,14,42,327
Development
Services
Advertising 179,31,42,647 179,31,42,647
and market
Promotion
Administrative 837,490,784 7,78,44,993
Support
Services
Total 294,24,29,967
4. The assessee filed objections before Dispute Resolution Panel, which, vide its order dated 20th September, 2011, gave various directions u/s 144C(5). The ITA No. 5637/D/2011 5 AO, in consequence to these directions, made a total adjustment to the declared prices of international transactions of Rs. 289,70,16,463/-, as under:
Segment Adjustment u/s Adjustment
92CA u/s 92CA
(Original) (Revised)
AMP 179,31,42,647 176,26,38,353
Segment
Software 1,071,442,327 105,57,45,127
Development
Services
Market 7,78,44,993 7,86,32,983
Support
Service
Segment
Total 2,94,24,29,967 289,70,16,463
5. Being aggrieved with the order of AO, the assessee is in appeal before us and has taken various grounds of appeal:
1. "That on the facts and circumstances of the case, the assessment order passed by the ld. Assessing Officer is bad in law;
2. That on the facts and circumstances of the case and in law, the ld. AO/Transfer Pricing Officer and ld. DRP erred in holding that the 'excessive' Advertising, Marketing and Promotion ("AMP") expenses incurred by the assessee is a Brand Promotion service rendered by the assessee to its Associated Enterprises ("AE") and that the appellant should receive additional arm's length price ("ALP") of Rs.
1,76,26,38,353/- from its Associated enterprise for such service. While concluding as above, the ld. AO/TPO and ld. DRP have erred in:
2.1disregarding the fact that the AMP expenses incurred by the assessee are transactions with domestic independent entities not covered by section 92 of the Act and that the analysis of domestic transactions with third parties, in respect of which no reference has been made to TPO, is beyond the powers vested with the TPO u/s 92CA of the Act;
2.2disregarding the fact that the ld. AO failed to independently apply his mind while making a reference to the ld. TPO in a mechanical manner without recording the reasons showing the necessity and expediency of the same; ITA No. 5637/D/2011 6 2.3ignoring the fact that once the assessee's transactions are accepted to be at arm's length after application of Transaction Net Margin Method as the most appropriate method, challenging the individual elements of costs (like the AMP cost) is inconsistent with the provisions of Transfer Pricing;
2.4ignoring that the pricing model of the appellant with its AEs in relation to its distribution activities suitably compensates the appellant for the alleged 'excess' AMP expenses;
2.5completely disregarded the fact that pursuant to the Group's Global Transfer Pricing policy, during FY 2006-07, the appellant received an amount of Rs. 1,506,756,362 from its AEs as a cost credit/purchase price adjustment. Post such credit from its AEs, the OP/Sales margin earned by the appellant was higher than the OP/Sales margin of comparable distribution companies in India; 2.6ignoring that the AMP expenses are incurred by the appellant solely for his own business and any benefit flowing to AE is only an indirect or incidental benefit; 2.7incorrectly considering the total local distribution and selling expenses as part of the AMP expense for comparison with the bright line limit, whereas the correct view should have been to include only the brand promotion expenses; 2.8incorrectly determining the AMP expense as 'excessive' by comparing against the bright line limit arrived at using inappropriate comparables that : (i) are not operating on the same level of the business value chain as that of the appellant; and (ii) are wholly dissimilar to the appellant in respect of the brands promoted by them; 2.9holding that the alleged 'excessive' AMP expense incurred by the appellant constitutes 'AMP service' provided to the overseas AEs and thereby adding a mark-up over and above the expense amount on arm's length basis; and 2.10determining the arm's length price of the alleged 'AMP service' by applying a mark-up of 11.11% on the alleged 'excessive' AMP expense computed on the basis of inappropriate comparables which are operating in business functions different from that of the appellant;
ITA No. 5637/D/2011 7
3. That the ld. AO and ld. TPO, on the facts and circumstances of the case and in law have erred in not following the binding direction issued by the ld. DRP regarding the inclusion of M/s Spice Mobility Ltd. and M/s General Sales Ltd. as comparables of the appellant for the purpose of computing the arm's length price of the alleged international transaction of "excessive" AMP expenses;
5. That on the facts and circumstances of the case and in law, the ld. AO/TPO and ld. DRP erred in enhancing the income of the appellant by Rs. 7,86,32,983/- by re- computing the ALP of the international transactions pertaining to Administrative and Marketing Support Service business segment of the appellant, and while doing so have grossly erred in:
5.1 rejecting the ALP determined by the assessee under the TP documentation maintained by the assessee u/s 92D of the Act read with Rule 10D of the Rules and also under the new search conducted by the appellant during the proceedings before the ld.
TPO without appreciating that none of the conditions given u/s 92C(3) have been satisfied. The authorities have also erred in carrying out a fresh search by rejecting/modifying the filters applied by the assessee; 5.2 disregarding multiple year/prior years' data as used by the assessee in the TP documentation and holding that current year (i.e. FY 2006-07) data for the comparable companies should have been used despite the fact that the same was not available to the assessee at the time of preparation of its TP documentation; 5.3 rejecting comparability analysis in the TP documentation/assessee's fresh search and in conducting a fresh comparability analysis based on application of the following additional/revised filters in determining the ALP for the administrative and marketing support service business segment;
5.3.1 exclusion of companies having different financial year ending (i.e. not March 31, 2007);
5.3.2 exclusion of companies with diminishing revenues/persistent losses for last three yeas upto and including FY 2006-07;
5.3.3 companies having other operating income (other than manufacturing and trading income) to sales greater than 75% were accepted; ITA No. 5637/D/2011 8 And rejecting the following filters applied by the appellant in his TP documentation/fresh search:
5.3.4 companies having other operating income (other than manufacturing and trading income) to sales greater than 50% were accepted; 5.3.5 companies with net worth less than zero were rejected; 5.3.6 companies having research and development costs to sales less 3% were accepted; and 5.3.7 companies having advertising, marketing and distribution costs to sales less than 3% were accepted;
5.4 including high profit making companies in the final comparables set for bench marking a low risk captive unit such as the assessee (disregarding judicial pronouncements on the issue), thus demonstrating an intention to arrive at a pre-
formulated opinion without complete and adequate application on mind with the single- minded intention of making an addition to the returned income of the assessee; 5.5 including certain companies that are not comparable to the assessee in terms of functions performed, assets employed and risk assumed; 5.6 resorting to arbitrary rejection of low-profit/loss making companies based on erroneous and inconsistent reasons;
5.7 excluding certain companies on arbitrary/frivolous grounds even though they are comparable to the assessee in terms of the functions performed, assets employed and risk assumed;
5.8 ignoring the business/commercial reality since the assessee is remunerated on an arm's length basis, i.e. it is compensated for all its operating costs plus a pre-agreed mark-up based on a benchmarking analysis, the assessee undertakes minimal business risks as against comparable companies that are fully fledged risk taking entrepreneurs, and by not allowing a risk adjustment to the assessee on account of this fact; and 5.9 committing a number of factual errors in accept-reject of comparables and/or in the computation of the operating profit margins of the comparables; ITA No. 5637/D/2011 9
6. That on the facts and circumstances of the case and in law, the ld.TPO and ld. AO erred in not following the binding directions issued by the ld. DRP in respect of the following:
(a) to make adjustment in the operating profit margins of the comparables chosen for administrative and marketing support service segment to account for the difference in the working capital levels of the appellant and the comparables;
(b) to verify the correct position regarding employee cost to sales filter in respect of Computech International Ltd. (Software Division); and
(c) to verify the correct position regarding export earning filter in respect of SQL Star International Ltd. (Software Development and Services).
7. That on the facts and circumstances of the case and in law, the ld. AO and ld. DRP erred in disallowing the provision for liquidated damages amounting to Rs. 20,15,37,175/-;
7.1 The ld. AO and ld. DRP erred both on facts and in law in holding that the claim for liquidated damages is a liability of future and not liability of present and thus does not represent liability for AY 2007-08;
7.2 Without prejudice to the above, the ld. AO erred in not following the directions of the ld. DRP in allowing the reversal of Rs. 30,67,79,345/- of the provision for liquidated damages;
8. That the ld. AO and the ld. DRP in complete disregard to the facts and legal position erred in disallowing the Computer Software expenses of Rs. 1,10,00,000/- on the ground that these are capital in nature;
8.1 Without prejudice to the above, the ld. AO erred in not following the direction of the ld. DRP stating that depreciation be allowed on the software expenses;
9. The ld. AO erred in both fact and in law in disallowing Rs. 8,82,63,570/- u/s 10A & 10B on the ground that the same was in the nature of deduction and, therefore, allowable to the extent of gross total income of Rs. 8,67,60,023/-; 9.1 Without prejudice to the above, the ld. AO further erred in restricting the 10A/10B deduction to the returned income and not following the directions of the DRP to ITA No. 5637/D/2011 10 compute the income of the assessee unit-wise and allow the higher deduction u/s 10A/10B than that claimed in the return;
9.2 Without prejudice to the above, the ld. AO has erred in not increasing the deduction u/s 10A/10B by disallowance on account of computer software expenses;
10. The ld. AO while determining the tax payable erred in not allowing credit of advance tax of Rs. 15,19,97,800/- and TDS of Rs. 14,46,51,326/-;
11. That the ld. AO erred in facts and in law in levying interest u/s 234D and sec. 244A(3) amounting to Rs. 58,59,630/- and Rs. 17,03,000/-.
12. The ld. AO has erred on the facts and the circumstances of the case and in law in arbitrarily intiating a penalty proceedings u/s 271(1)(c) against the appellant for furnishing inaccurate particulars of income."
5.1 Ground No.1 is general and does not require any adjudication. Ground No.2 :- Issue Relating To AMP Expenses
6. Brief facts apropos ground no. 2 are that while examining the distribution segmental profitability chart submitted by the assessee, TPO noticed that the assessee had debited following expenses under the head "advertisement and market promotion activities" (in short AMP Expenses) to the Profit & Loss Account:
1) Advertisement and sales promotion 1469952312/-
2) Business meetings and conferences 182405029/-
3) Dealer commission 8,71,07,635/-
Total 173,95,24,976/-.
The TPO pointed out that this was around 7.385% of the total sales (2355.44 crores) made by the assessee. He, accordingly, issued show cause notice to assessee which has been reproduced at pages 192 to 194 of his order. In this notice TPO, inter-alia, made following observations:ITA No. 5637/D/2011 11
i) By incurring this expenditure, the trade name of Motorola Inc. is being promoted.
ii) From the TP report it is evident that there is no agreement between Motorola Inc., USA and MIPL (Assessee) for incurring of advertisement and selling expenses and compensation for the same.
iii) The expenditure is in the nature of Intra Group Services provided by the assessee company for which no cost or mark up thereof have been received by the assessee company.
6.1 The assessee's reply has been summarized at page 194 to 195 of his order as under:
"The powers of TPO vested u/s 92CA(2) are limited to the reference made to him by the AO;
Once the TNMM method is applied, the transactions cannot be benchmarked separately. The application of TNMM necessarily stipulates aggregation of transaction;
The AR for the assessee has placed reliance on the following judgments:
• Star India Pvt. Ltd. vs. ACIT (3585/M/2006);
• Nestle India Ltd. vs. DCIT (111 TTJ 53) and
• Sony India Pvt. Ltd. vs. DCIT (1189/Del/2005).
The assessee performed all marketing activities on its own account and not for the benefit/on behalf of its AE. No direct benefit accrued to AE as a result of marketing activities undertaken by Motorola India. It was further submitted that the assessee had incurred expenditure on advertisement and sales promotion ITA No. 5637/D/2011 12 in respect of only those products in which Motorola India was dealing and the expenditure was incurred wholly and exclusively for the purpose of business of Motorola India.
The AMP expenditure is necessary and incurred in ordinary course of business.
As a result of advertisements and sales promotion activities, the sale of Motorola products had increased in India which had benefited the assessee more than because the holding company i.e., AE had never sold goods directly to customer in India. Accordingly, ultimate beneficiary of advertising and sale promotion activity was the assessee and not the AEs.
Motorola India incurred expense on account of advertisement and sale promotion activities with a sole intention of developing marketing in India for its product.
The business model of the assessee is such that the assessee company is already getting credit notes for reimbursement in trading account, to sustain a constant profit margin. As per the Group's Global Transfer Policy, during FY 2006-07,theassessee received an amount of Rs. 1,506,756,362 from its AEs as a cost credit/purchase price adjustment."
6.2 The TPO disposed off the assessee's objections as under:
1) As regards the first objection raised by the assessee that TPO is to determine the ALP of the international transactions on reference being made by the AO to the TPO, the TPO pointed out that the AO had sent separate reference for AMP expenses vide his letter dated 19th October, 2010. ITA No. 5637/D/2011 13
2) The TPO further pointed out that it was a matter of record that the AE of the assessee and its parent company Motorola Inc. had acknowledged an increase in its sale due to the marketing efforts of the assessee in India and, therefore, since the benefit had been received by the parent company from the effort of assessee, for which assessee had not been compensated, therefore, under the transfer pricing regulations, the arm's length price of such compensation had to be determined. He further pointed out that the assessee had not bench marked the international transaction of receipt of reimbursement and, therefore, the international transaction of receipt of reimbursement had to be determined.
3) As regards the assessee's objection "that the business meetings and conferences " and "dealer commission" expenses are in no manner related to "brand building activities"/promoting brand name of AE's, the TPO pointed out that the contention of the assessee was not based upon any reasoning. He further pointed out that it is not understandable as to why a distributor would spend in events like business meetings and conferences but for the promotion of its products and brands. He pointed out that by incurring these expenses, assessee was creating intangibles, the fruits of which, it was going to reap over the times to come. Similarly, he pointed out that the same was the situation with dealer commission. He, accordingly, rejected this contention of the assessee.
4) As regards the last contention of assessee that assessee company was already getting credit notes towards reimbursement in trading account, to ITA No. 5637/D/2011 14 sustain a constant profit margin as per the groups global transfer pricing policy, the assessee received an amount of Rs. 1506756362/- from its AE as a cost credit/purchase price adjustment, the TPO observed as under:
"Another contention of the assessee is regarding the Global transfer price policy of the group. As per this policy, during FY 2006-07, the assessee received an amount of Rs. 1,506,756,362/- from its AEs as a cost credit/purchase price adjustment. The assessee is trying to claim it in the form of compensation of AMP activities done by it. The contention of the assessee does not have any force. Nowhere in the TP study, it is mentioned that the assessee is receiving some compensation from its AE in the form of credit notes for the AMP activities being undertaken by the assessee. It was only during the TP audit proceedings that when the issue of AMP was taken up, the assessee started claiming the credit notes to be the compensation for AMP activities. The assessee has not been able to produce any documentary evidence in the form of credit notes itself, or any other communication or any other supporting evidence to prove that the credits received by the assessee from its AE are the compensation for AMP expenses. In fact the assessee itself is stating that these are the credits for purchase price adjustments. Therefore, by no stretch of imagination the purchase price adjustment credits, can be taken as compensation for AMP activities undertaken by the assessee.
Therefore, the contention of the assessee in this regard is without any basis and is therefore rejected."ITA No. 5637/D/2011 15
6.3 The assessee's objections as regards comparables selected by TPO, in regard to AMP Expenses, were disposed of as under:
a. "As regards Cyber Media Online, the objection of the assessee was that the company has high Related Party Transaction. The data on Prowess shows that the company has 100% of its revenue from Advertisement activities. The RPT in the case of this company is less than 25% hence this objection is also rejected. This company was itself taken by the assessee as comparables in its Transfer Pricing Report in class III category of transactions. There is no effect of shared expenses on the operating results of the assessee, as objected by the assessee and, hence, this company is accepted as a comparable. b. As regards M/s Rockman Advertisement and Marketing India Limited, the assessee has submitted that the company is also actively involved in other related activities such as film and documentary production. The assessee has relied on the part information taken from the website. I have examined the data available on the Prowess database and it is seen that 100% of its revenue is from Advertisement activities. I, therefore, reject the objections of the assessee in this regard. This company is accepted as a comparable."
7. Accordingly, the TPO proposed to compare AMP Expenses of the tested party with AMP expenses of other comparables engaged in distribution business in order to bench mark the cost of Intra-Group Services provided by the assessee company to Motorola Inc. He adopted AMP Expenses to sales as PLI ratio for comparability analysis. The TPO referred to five comparables used by assessee and pointed out as under:
ITA No. 5637/D/2011 16
a) Mobile Telecommunication Ltd. No annual report available for FY 2006-07.
b) HCL Infinet Ltd. No annual report available for F.Y. 2006-07.
c) HCL Infosystem Ltd., from the annual report it was seen that this company was engaged in brand building and was getting reimbursement from the group company so it could not be taken as comparable for this analysis.
d) Salora International Ltd.
Discount commission and publicity Rs. 79.23 lakhs.
Advertisement and Publicity Rs. 98.38 lakhs Total Rs.177.61 lakhs Total sales Rs.1727.94 lakhs ( % of AMP to sales .19%) e) Shyam Telecom Ltd. AMP Expenses Rs. 2676364/- Sales Rs. 2393579206/- (% of AMP to sales 1.11%)
7.1 Considering the aforementioned five comparables, the TPO proposed the bright line percentage of AMP at .65% to sales being average of the AMP expenses incurred by Salora International Ltd. and Shyam Telecom Ltd. He, accordingly, proposed to treat 6.735% (7.385 - .65) of the expenditure of the assessee company, which worked out to Rs. 158639382/-, as expenditure which the assessee had incurred on advertisement and publicity for promoting the brand name of Motorola Inc. for which no payment had been received by the assessee company. In view of these facts he treated the expenditure ITA No. 5637/D/2011 17 incurred by assessee, over and above the bright line, as an international transaction u/s 92B(1) read with clause (v) of section 92F. 7.2 He further pointed out that no independent enterprise would incur expenditure for promoting the trade names owned by some third party unless duly compensated for such efforts. He proposed a mark up @ 13.04% on the AMP expenditure.
7.3 He, accordingly, determined the arm's length compensation for AMP services as under:
Expenditure in excess of bright line (A) 158,63,90,382 Markup on above @ 13.04% (B) 20,68,52,265 Total of (A) & (B) above 179,31,42,647 7.4 The assessee filed objections before DRP after considering which, DRP directed the TPO to examine the assessee's objection in regard to exclusion of comparables by TPO, as under:-
"As regards exclusion of Spice Mobility Ltd. by TPO on the grounds that it is promoting its own brands, we have considered the submissions of assessee.
According to assessee, Spice brand is owned not by Spice Mobility (company proposed by assessee) but by Spiceorp Entertainment Ltd. Similarly, Lexus brand is not owned by General Sales Ltd. (Co. Proposed by assessee) but by Usha Sriram Entrprises. In view of the above explanation, Spice Mobility and General Sales Ltd. being functionally similar must be taken as a comparables.
TPO is directed to include both after verification regarding ownership of brand."ITA No. 5637/D/2011 18
7.5 As regards, Rockmen Advertisement & Marketing India Limited, the assessee, with reference to website of company, pointed out that this company was engaged in carrying out activities relating to film and, documentary production and, therefore, could not be included as a comparable to determine the markup on the excess AMP. It was further pointed out that the turnover of this company was very low inasmuch as it had booked sales revenue of Rs. 1.4 crores during the said year. As against this, alleged excess AMP on which a markup was proposed to be applied was 158 crores. The assessee, relying on the decision in the case of Sony India, pleaded for exclusion of this comparable. 7.6 After considering the directions of ld. DRP, the AO, in his final order revised the adjustment at Rs. 176,26,38,353/-.
8. At the outset, ld. Counsel for the assessee filed before us an application for admission of additional evidence which is reproduced hereunder:
Filing of Additional Evidence (as per Rule 18(4) read with Rule 29 of the ITAT Rules Advertisement and Marketing Promotion expenses (Ground No. 1 of the Appeal)
1. Background An addition of Rs. 2,17,04,89,288 has been made on account of the order passed by the ld. TPO holding that the appellant has incurred advertising and marketing promotion ("AMP") expenses incurred by the Appellant is a brand promotion service rendered by the Appellant to its Associate Enterprise ("AEs") and this excess expense ought to be reimbursed by the parent of the appellant along with a mark up thereon.
During the proceedings before the ld. TPO, the Appellant had submitted that certain credit notes were received by the appellant for not meeting the arm's length mark up for its trading operations and is in the nature of compensation/subsidy received by way of discounted transfer price for products purchased from the AEs which should be taken into account in considering the present issue of AMP. However, these inter-company ITA No. 5637/D/2011 19 receipts were not considered by the ld. TPO. In the proceedings before the DRP, these credit notes were not discussed since the methodology of how to compute the addition on the AMP expenses was not clear. The Hon'ble DRP never asked the appellant to furnish any supporting evidence in respect of credit notes. In the recent ruling [ITA 5140/Del/2011] of the Special Bench of Delhi Income-tax Appellate Tribunal (SB) in a group of cases involving several taxpayers, with lead case being that of Ms. L.G. Electronics India Private Limited vs. ACIT, the Special Bench has categorically mentioned "subsidy on purchases" as a factor to be taken into account while computing bright line.
Following this new development, the Appellant wishes to reiterate its facts with additional evidence in the form of summary of credit notes received, sample copies of the credit notes and sample copies of the Foreign Inward Remittance Certificates. This additional evidence goes into the root of the matter and may by admitted in the interest of justice.
2. Additional Evidence The appellant would like to bring to your notice that Rs. 3,465,141,270. of credit notes were received by the appellant in AY 2008-09 in its trading operations. A summary of credit notes received in this regard are enclosed as Annexure 1. Sample copies of the credit notes are enclosed as Annexure 2. Sample copies of the Foreign Inward Remittance Certificates issued by the bank on receipt of the money are enclosed as Annexure 3.
Prayer The appellant humbly prays before your Honour to kindly take the additional evidences on record.
Thanking you, Yours Faithfully Sd/-
For Motorola Solutions India Private Limited (Ramadorai Raghupathy Meyoor) (Director) Dated: April 5, 2013.
ITA No. 5637/D/2011 2017.1 Ld. Counsel submitted that the Spl. Bench in LG's decision has, inter-alia, ruled that subsidy given by the foreign AE in any form including in the form of subsidiary towards purchases made from the AE has to be off set from the excess AMP expenditure.
9. Ld. Counsel for the assessee relied on the detailed written submissions in this regard contained in the paper book. The basic contention advanced by ld. Counsel for the assessee, Sh. Himanshu Sinha, is that as the profit margin of the assessee being 5% was much more than that of the independent comparable being 1%, the assessee's international transactions were at arm's length. Ld. Counsel submitted that the credit notes issued by Motorola Inc. fully reimbursed any expenditure, if any, incurred by assessee benefitting the principal. The contention is based on the guidelines laid down by Spl. Bench in the case of M/s LG Electronics India Pvt. Ltd. vs. ACIT wherein it has been, inter-alia, laid down that if AE has ,in any manner like subsidy on purchases, has reimbursed the assessee, then the same has to be considered for determining excess AMP expenditure.
9.1 Ld. Counsel submitted that as per the transfer pricing policy of the Motorola Group, the compensation model of the assessee is structured in such a manner that the reimbursement of any excess third party expenses (including the alleged AMP Expenses) is already built in the transfer pricing adjustment compensation received by the assessee which allows it to consistently earn an operating margin which is higher than the comparables. In this regard ld. Counsel referred to page Nos. 245 to 264 of paper book, wherein the method of ITA No. 5637/D/2011 21 adjustment in the transfer price is provided. He referred to para 4.1 of transfer pricing policy which reads as under:
"The Distributor Net Margin Method of transfer pricing determines transfer price by reference to both a third party end user product price and a comparable distribution net margin. The method focuses on the profits/losses generated by the Related Party distribution operations. Specifically, the method requires that a range of Net Margins be generated for comparable, uncontrolled distributors. A range of comparable results is used because of the variety of price and profit outcomes that arise in arm's length transactions. Comparable, uncontrolled distributor results are obtained from published industry databases through a screening process that looks at the industry SIC codes and uses the subsidiary functional analyses to determine the comparable, uncontrolled distributors. From the comparable ranges which are generated,prices are established by the factory legal entity that aim to return to the Related Party distribution operations a net margin for the current year that falls at the midpoint of the Multi-Year Net Margin Range. However, if the Related Party distribution operation has an average net margin for the current year plus the two preceding years (the "3 year average"), which is outside the Multi year Net Margin Range, then the current year's transfer price will be set to move the 3 year average closer to the Multi Year Net Margin Range, while still keeping the current year within the Net Margin Range."
9.2 Ld. Counsel submitted that this plea was taken before TPO also. In this regard he referred to page 293 of paper book containing the submissions ITA No. 5637/D/2011 22 made before lower revenue authorities wherein it was, inter-alia, submitted as under:
"Thus, given the facts of the present case, the assessee already has a favourable pricing policy with its overseas group companies. Accordingly, since the pricing model of the Company already takes into account the AMP expenses incurred by the Indian entity, the question of recovery of the same again from the overseas group companies does not arise. Such an act/adjustment by your goodself would tantamount to considering/setting off/recovering the same amount twice by the Indian company from the overseas group companies, which cannot be a logical conclusion by any stretch of imagination."
9.3 Thus, it was submitted before the TPO that assessee had received more than adequate subsidy as price adjustments by way of credit notes and, therefore, excess AMP expenditure, if any, got adequately compensated by this subsidy. However, the TPO rejected the assessee's contention on the ground that the assessee had not been able to produce any documentary evidence to prove that the credit notes received by the assessee from its AE were towards compensation for AMP expenses. Ld. counse, therefore, submitted that credit notes needs to be admitted. He further submitted that TPO should be directed not to insist on establishing direct nexus of credit notes with the AMP Expenses. In this regard ld. Counsel pointed out that in LG's case in para 17.4, factor no. 9, Spl. Bench has merely laid down that one of the considerations is where the foreign AE's compensated the Indian entity for the promotion of its brand in any ITA No. 5637/D/2011 23 form, such as subsidy on the goods sold to the Indian AE, the same has to be set off against the excess AMP expenses and in factor 10 it is laid down that where such subsidy is allowed by the foreign AE, whether the amount of subsidy is commensurate or not with the expenses incurred by the Indian Entity on the promotion of brand for the foreign AE is to be examined. He, therefore, submitted that it is not necessary that there should be a direct nexus with the subsidy and AMP expenditure and if it can be established that assessee was duly compensated towards the alleged excess AMP expenditure by demonstrating that the operating profit margin to sales was commensurate or better than that of the independent comparables then no further addition can be made on account of TP adjustment else it would lead to double addition. 9.4 In support of his contentions ,ld. Counsel relied on the decision in the case of BMW India Pvt. Ltd. vs. Addl. CIT which was filed before us by way of additional submissions dated 27th August, 2013, after the hearing was over. In the petition the assessee stated as under:
"The hearing in the above-captioned appeal was concluded on July 18, 2013 before Bench "I" comprising of Hon'ble Members Mrs. S.V. Mehrotra and Ms. Diva Singh and the order has been reserved in the case. The order is still awaited in this matter.
In the meantime, "I" Bench has delivered its judgment in the case of BMW India Pvt. Ltd. vs. Addl. CIT (ITA No. 5354/Del/2012) which has a direct bearing on one of the main grounds of appeal in the above-captioned appeal. ITA No. 5637/D/2011 24
The Appellant, is accordingly, filing an application along with the copy of the BMW India judgment for the kind consideration of the Hon'ble Members who have heard our case. The application and copy of the said judgment are attached herewith.
Your are requested to kindly place the application along with the judgment before the Hon'ble Members so that the same may be considered by them while deciding the grounds which stand covered by the said judgment."
Additional Written Submission and Application to consider the judgment of BMW India P. Ltd. vs. Addl. CIT (ITA No. 5354/D/2012):
1) That the hearing in appeal no. ITA 5637/Del/2011 for A.Y. 2007-08 were concluded on July 18, 2013 and the order was reserved on that date. The matter is now awaiting pronouncement of the decision by Your Honours.
2) That in the meantime, the "I" Bench of the Hon'ble Income Tax Appellate Tribunal, New Delhi has pronounced its decision in the case of BMW India Pvt.
Ltd. vs. Addl. CIT (ITA No. 5354/D/2012 for AY 2008-09). The said order was passed on August 16, 2013.
3) The main issue decided in the said BMW India judgment is in respect of AMP expenditure. In the present appeal, Ground Nos. 2.1 to 2.10 and 3 are also in respect of the AMP issue.
4) Due to high degree of similarity of facts between our case and that of the BMW India case has a direct bearing on the AMP issue which is part of Grounds no. 2.1 to 2.10 and 3 of our appeal."
ITA No. 5637/D/2011 25
10. After considering the contents of application, it was considered necessary to hear both the parties in regard to the applicability of decision to assessee's facts. Accordingly, on 3rd September, 2013 the case was re-fixed for further hearing after recording following order-sheet noting:
"The assessee has filed additional submissions dt. 27/08/2013 enclosing therewith a copy of order in the case of BMW India P. Ltd. Vs. Addl. CIT (ITA No. 5354/D/2012). The copy of submission, as per endorsement on petition, has also been delivered to ld. CIT(DR), Bench-I by assessee. Therefore, the appeal is posted for further hearing as part-heard on 26/09/2013 at 2.30 p.m. Issue notice to both the parties."
11. The assessee filed a summary of decision in BMW India Pvt. Ltd. vs. Addl. CIT to demonstrate the similarity of facts between BMW and assessee on the ground that the assessee is the sole distributor of mobile phones, telecom equipment and other ancillary product manufactured by its parent Motorola, US like BMW which is also a sole distributor.
12. Ld.CIT( DR) submitted that before TPO, the assessee had not filed any documentary evidence to support its contention that AMP Expenses had duly been compensated by the alleged credit notes. He, therefore, vehemently opposed the admission of these additional evidences.
12.1 Ld. CIT(DR) further submitted that if assessee's contention is accepted then it would lead to an anomalous situation. In this regard ld. CIT(DR) has filed following working which is reproduced hereunder: ITA No. 5637/D/2011 26
Situation 1 "Working of Taxable Income relating to service of brand building by incurring excess AMP expenditure (over ALP or over Brightline) Let us Say -
Description Amt.
(Rs.)
A Sale 2000
B ALP or Bright line limit 60
of AMP expenditure
@ 3% of sales.
C Actual AMP 100
Expenditure by Indian
entity.
D Excess AMP 40
Expenditure [Rs. 100
less Rs. 60]
E ALP mark up on 4
Service of Brand
Building @ 10% on
excess AMP
expenditure i.e. 10%
of Rs. 40
F Total Recovery to be 44
made by Indian entity
[Rs. 40 + Rs. 4]
G Taxable Income on 4
a/c service of Brand
Building for foreign
AE, by incurring
excess AMP
expenditure over
Bright Line ALP
Situation 2
Excess AMP Spend [D] Rs. 40
Amount actually reimbursed on a/c of Subsidy Received [H] Rs. 30 Remaining Amt. to be received [I] Rs. 10 ALP markup on brand building @ 10% of excess AMP spend has to be 10% of Rs. 40 which is Rs. 4. [G].
However, according to assessee, a mark up on brand building has to be on the sum of Rs. 10 which @ 10% of excess amount spent has to be Rs. 1 - [J]. Thus, by the non-specification of purpose of subsidy the assessee has reduced the income by Rs. 3."ITA No. 5637/D/2011 27
12.2 Ld. CIT( DR) further submitted that determination of arm's length price in regard to AMP Expenses in case of Distributors is squarely covered by the decision of LG Electronics para 21 page 99 - 100. He submitted that each international transaction has to be separately evaluated as held in LG Electronics case. Ld. CIT(DR) further submitted that subsidy has been given for sale of goods in India and not for intangible items like brand building.
Therefore, the subsidy cannot be taken as given for developing brand in India. He submitted that cross subsidizing concept is not allowed in India. The matter needs to be examined by AO. Ld. CIT(DR) submitted that there has to be an agreement between assessee and its AE regarding expenditure in connection with brand building then only subsidy could be allocated. Express understanding regarding brand building had to be there for appropriating subsidy. Ld. CIT(DR) submitted that nexus has to be there with brand building because there may be different international transactions against which subsidy might have been given. Therefore, it is necessary that facts be properly appreciated in order to find out against which international transaction subsidy is to be applied. Ld. CIT(DR) pointed out that the promotion of brand has to be specific but in the present case there was no specific agreement to this effect. He further pointed out that brand building was not reported as a separate international transaction by assessee. Ld. CIT(DR) further submitted that TPO has determined excess AMP Expenses at Rs. 176,26,38,353/- as against which subsidy has been claimed of Rs. 1506756362/-. Thus, if assessee's contention is to be accepted then entire subsidy was towards brand building expenses ITA No. 5637/D/2011 28 which obviously was not. Ld.CIT( DR) further explained with the help of an example that supposing against excess AMP Expenses of Rs. 110/- subsidy of Rs. 171/- is received then difference may be for some other transactions and not for brand building. He further submitted that the concept of subsidy being brought in before TPO is primarily an after thought because once TPO held the brand building as international transaction then assessee came forward with plea that credit notes were towards brand building.
12.3 Ld. DR filed written submissions which are placed on record and submitted that the issue regarding AMP expenses has to be decided in view of LG's decision and the decision in the case of BMW's case has been rendered keeping in view the peculiar facts obtaining in that case. 12.4 Regarding ld. DR's submission that each international transaction has to be separately bench marked, ld. DR has filed written submissions which are reproduced hereunder:
"This is for the reason that law mandates that each international transaction has to be separately bench marked. (Please refer to para 15.1 of the order in the case of M/s LG Electronics India P. Ltd. A.Y. 2007-08, ITA No. 5140/D/11). The whole para is relevant, and the first 5 lines are indicative of the discussion in this paragraph,- "15.1 At this stage, we feel it productive to have a macro view of the transfer pricing provisions. Section 92 provides that the income from an international transaction shall be computed having regard to ALP. What is an international transaction and who is an associated enterprise has been defined in sections 92B and 92A respectively."
The need for specific attribution of subsidy towards a specific international transaction can be understood by the following example-
ITA No. 5637/D/2011 29
S.No Natures of Book Price Arms Remarks
Transaction (Rs.) Length
Price
(Rs.), as
Determin
ed by
TPO
1. Import of TV 1,00,000 60,000 The
Tubes (Price Assessee
paid) has paid
excess
price to
the extent
of Rs.
40,000/-
2. AMP Nil 20,000 The
Expenditure Assessee
towards has not
Brand received
Building (that Rs.
should have 20,000/-
been received from the
from AE), (a AE,
Transaction though it
not reported should
by assessee). have
received
the same.
3. Subsidy 30,000 It has not
received been
specified,
as to the
purpose
for which
subsidy
has been
received.
According to the assessee, the subsidy is to be applied to AMP expenditure. If such is the situation then ALP of AMP expenditure, according to the assessee, would be Rs. (-) 10,000/-, (Rs. 20,000 being ALP of AMP expenditure less Rs. 30,000 being subsidy). This is an absurd result."
12.5 Ld. CIT(DR) further submitted that following observations in LG's case are also relevant for the proposition that each transaction has to be separately bench marked and the overall profit margin is not relevant for deciding this issue:-
21.1 "The ld. Counsel for the appellant started his contentions on this point by urging in the very beginning that no disallowance can be made out of AMP expenses by benchmarking them separately when the overall net profit rate declared by the assessee is higher than other comparable cases. It was submitted that the assessee made imports from its foreign AE which were subjected to the TP provisions under the transactional ITA No. 5637/D/2011 30 net margin method (hereinafter called the TNMM) and hence there was no warrant for making any further addition on the transaction of brand building expenses incurred by the assessee for the foreign AE. The ld. counsel stated that the overall higher net profit rate implies that, firstly, there was no advertisement by the assessee for the brand of the foreign AE and secondly, if at all it was there, the same stood compensated by the foreign AE in terms of sale of goods to the assessee at lower rates. The sale of goods at lower prices to the assessee by the foreign AE should be considered as a quid pro quo for the foreign brand building. For ascertaining as to whether or not the foreign enterprise sold goods to the assessee at a lower price, the ld. AR urged that the overall net profit rate of the assesee should be considered, which will naturally absorb the effect of incurring such brand building expenses. If the overall profit rate is higher, it will mean that the expenses incurred by the assessee on brand building were compensated by the foreign AE in terms of lower price of goods charged from the Indian AE, necessitating no separate further addition on the alleged presumption of the assessee having incurred any AMP expenses towards brand building. The ld. AR relied on the case of the Hon'ble Supreme Court in CIT vs. Calcutta Discount Co. Ltd. (1973) 91 ITR 8 (SC), to canvass the view that the assessee cannot be expected to earn maximum profit. It was submitted that the action of the Revenue in firstly taxing higher rate of net profit on sales and thereafter further increasing the income by making addition on account of AMP expenses, runs contrary to the cardinal principle laid down in that case. He explain that in that case the Revenue opined that the assessee should have transferred its goods at a higher price than that declared. Rejecting this contention, the Hon'ble Supreme Court came to hold that once a transaction is bona fide, the profit cannot be computed by taking market price, ignoring the real price fetched. In the light of this judgment it was contended that the action of the Revenue in firstly benchmarking the net profit by applying TNMM on the international transaction of imports and then making separate addition for AMP expenses is akin to the stand of the Revenue in that case, being the maximization of profit in all possible ways, which cannot be sustained. With reference to certain material from the paper book, the ld. AR submitted that the assessee's net profit rate was better than certain other comparable ITA No. 5637/D/2011 31 cases. Since the overall net profit of the assessee was relatively higher, it was pleaded that no addition was called for by separately processing any item of expense including the AMP under the TP provision. Similar arguments were advanced by the ld. counsel for some of the interveners.
21.2 Per contra, the ld. DR strongly opposed this contention by submitting that there is no requirement under law that if one transaction has been subjected to the transfer pricing provisions by applying the TNMM then no other international transaction can be separately considered. It was accentuated that all the international transactions are required to be viewed independent of each other.
21.3 "We have heard the rival submissions on this issue in the light of material placed before us and precedent relied. The crux of the ld. AR's submission in this regard is that when the international transaction of import of raw material was scrutinized by the TPO under TNMM and the overall net profit of the assessee was found to be higher than other comparables, then no other international transaction could have been processed under the TP provisions. There are two sub-arguments in this main argument of the ld. AR. First, that the international transaction of import of raw material has been processed under the TNMM on entity level and second that when on doing this exercise, the overall net profit was found to be better than other comparables, then the no addition was called for by subjecting the AMP expenses to the TP provisions.
21.4 There is a basic fallacy in the first sub-argument, which lies in not properly appreciating the modus operandi of applying the TNMM. This method provides for benchmarking of an international transaction by considering the operating profit from the concerned international transaction vis-à-vis certain basis as given in Rule 10B(1)(e), being total cost, sales, capital employed etc. Here it is significant to note the meaning of the term 'transaction' as given in rule 10A(d). It provides that: 'transaction includes a number of closely linked transactions'. Plural of transactions becomes singular when the transactions are closely linked to each other or are identical. These closely linked transactions can be processed as one transaction under any of the prescribed methods. If an Indian enterprise has made sale of similar goods to its ITA No. 5637/D/2011 32 foreign AE through several invoices and has also incurred some expenses or paid interest to it, it would mean that all the transactions of sales are closely linked and these can be processed as one unit. However, the transactions of payment of interest or incurring of any other expense would be required to be separately scrutinized under Chapter-X because these are of a different nature vis-à-vis the transactions of sales. 21.5 It is undisputed that under the TNMM, it is always the operating profit from the concerned international transaction that is viewed in relation to the total cost, sales or capital employed etc. of that international transaction. It is not as if the percentage of the margin is to be determined by considering the net profit of the entity in relation to the total sales of the entity. When we consider operating profit to total costs of an international transactions, all the items of non-operating expenses and non-operating income qua such international transaction are liable to be excluded. The correct approach under the TNMM is to consider the operating profit from each international transaction in relation to the total cost or sales or capital employed etc. of such international transaction and no the net profit, total costs, sales, capital employed of the assessee as a whole on entity level. Section 92C unequivocally provides that the ALP in relation to 'an' international transaction shall be determined by any of the prescribed methods. In turn, rule 10B(1)(e) also talks of the net profit margin realized by the enterprise from 'an' international transaction. When the mandate of the section and the relevant rule is unambiguous so as to apply on each transaction, as is apparent from the use of the article 'an', then the computation of the ALP of 'an international transaction on the entity level is inappropriate. Our conclusion that each international transaction is required to be separately scrutinized under Chapter X also becomes apparent from the language of section 92(3) as discussed infra. Thus, it is clear that the sanction is for applying the TNMM only on a transactional level and not on entity level. Of course, the TNMM can be correctly applied on entity level if all the international transactions are of sale by the assessee to its foreign AE and there is no other transaction of sale to any outsider and also there is no other transaction of sale to any outsider and also there is no other international transaction. But if there are several unrelated international transactions, as is the case before us and the assessee ITA No. 5637/D/2011 33 or the TPO has applied the TNMM in a wrong manner or entity level for testing any of such transactions, then the remedy lies in correcting such mistake rather than drawing legally unsustainable conclusions by taking such mistake as a correct legal position. 21.6. Now we espouse the second sub-argument that when on applying the TNMM on entity level for the transaction of import of raw material the overall net profit is better than other comparables, then no addition is called for by subjecting the AMP expenses to the TP provisions. We have held in an earlier para that when there are different unrelated international transactions, the application of TNMM on entity level for examining one of such transactions, is itself an incorrect approach. Notwithstanding that, we deem it expedient to deal with the argument of the ld. AR that if rate of net profit of the assessee is better than other comparables, then no adjustment can be done under Chapter-X. 21.7. On a specific query from the Bench, it was admitted by the ld. AR that no addition was made by the TPO on account ofapplication of the TNMM on the imports made by the assessee from its foreign AE. In our considered opinion, there is a noteworthy difference between two situations, viz., one where the TNMM is wrongly applied on entity level and some addition is made to the overall net profit of the Indian AE while testing the international transaction of imports of raw material and also some further addition is made by applying the TP provision on AMP expenses; and the situation in which no addition is made to the overall profit on account of application of the TNMM but an addition is made by applying the TP provisions on the transaction of AMP expenses incurred towards brand building for the foreign AE. 21.8. We find no bar on the power of the TPO in processing all international transactions under the TP provisions when the overall net profit earned by the assessee is better than others. Earning an overall higher profit rate in comparison with other comparable cases cannot be considered as a licence to the assessee to record other expenses in international transactions without considering the benefit, service or facility out of such expenses at arm's length. All the transactions are to be separately viewed. This position can be seen with a simple illustration. Suppose an Indian entity is engaged in manufacturing of some products and all the sales are to its ITA No. 5637/D/2011 34 foreign AE. In such international transaction, it earns actual profit of, say, 120/-.
Further suppose the arm's length profit on total sales earned in comparable uncontrolled transactions is `100. In such a case, there can be no question of making any addition on account of arm's length profit from such international transaction of sale to foreign AE because the actual overall profit is more than the arm's length profit. It may also be possible that the actual profit of the Indian AE was 140/- but the AMP expenses have been so claimed as deduction so as to include a part representing branding building for the foreign AE to the tune of `20/-. In such a case, notwithstanding the fact that the assessee's overall profit at `120/- is more than the arm's length profit earned by comparable cases at `100/-, still there will be a requirement for making adjustment of `20/- on account of advertisement expenses incurred by the assessee towards the brand building on behalf of the foreign AE. If we accept the assessee's contention that since `120/-, being the profit declared by the assessee from the international transaction is more than the arm's length profit of `100/- and hence no further adjustment on account of AMP expenses should be made, then the assessee's income would stand reduced to `120/- as against the actual income of `140/-. We fail to appreciate as to how the judgment in the case of Calcutta Discount Co. Ltd. (supra) advances the case of the assessee. There cannot be any quarrel on the proposition that the assessee cannot be compelled to earn maximum profit. As it is the real profit which is to be taxed and the assessee cannot be expected to earn maximum profit, in the same way, the assessee cannot be allowed to reduce its real profit by including certain expenses which are for the benefit of the foreign AE. 21.9. It is pertinent to note that presently we are dealing with a case in which the majority of the assessee's sales is to Indian customers. Naturally the TP provisions cannot be applied in respect of sales to Indian customers because these are not international transactions. In such a case, there can be no benchmarking of the profits realized from such Indian customers so as to form a platform for contending that the TNMM has been applied on the overall profits and hence the AMP expenses should not be subjected to the TP provisions. In fact, the assessee is a manufacturer and only raw materials are imported from its foreign AE. The transaction of import of raw-material ITA No. 5637/D/2011 35 is a separate international transaction liable to be subjected to the TP provisions. Apart from such purchase of raw material, the assessee, as a manufacturer is also required to incur several other expenses on manufacturing, financing and selling which constitute part of the total cost of product along with the cost of raw materials. Subjecting the international transaction of purchase of raw material to the TP provisions would only show that purchase price of raw-material is not unnecessarily inflated. It is self evident that net profit is not dependent only on the purchase cost. A host of other factors contribute to the earning of profit. It may be possible that a manufacturer succeeds in making economical purchases but suffers setback in incurring other expenses thereby resulting into a comparatively low profit. Similarly there can be a converse situation in which the purchases are made costly but the economies in other areas are achieved thereby leading to higher profit. The crux is that purchase cost is only one of several other important factors having a bearing on the overall profit. All other costs, including the AMP expenses are independent of such cost of import of raw material, having some correlation with the overall profit. In our considered opinion there is no logic in not applying the TP provisions on AMPexpenses, if the international transaction of import of raw-material from the foreign AE has been subjected to the TP provisions. As the transactions of import of raw-material and AMP expenses are distinct from each other, having independent effect on the overall net profit of the Indian AE, both are required to be separately processed as per the TP provisions.
21.10. It was also contended on behalf of the assessee that if the overall profit of the Indian entity is more than the comparable cases then it should be presumed that the foreign enterprise supplied goods at relatively low price to make up for the AMP expenses incurred in India towards brand promotion. In our considered opinion there are no roots for such a presumption. In order to take benefit of such a contention the assessee is required to directly prove the fact of cheap purchases de hors the overall higher net profit rate. This fact can be established by demonstrating that the foreign AE charged a specially low price from the assessee in comparison with that charged for the similar goods supplied to other independent entities dealing with it in ITA No. 5637/D/2011 36 India or in case there is no other independent entity in India, then the price charged for similar goods from other foreign parties. It can also be proved by showing that goods with identical features are available in the Indian market at a higher price. The fact that the assessee has a better net profit rate in comparison with other comparable entities is not decisive in itself of the assessee having purchased the goods at a concessional rate from its foreign AE as a compensation for its incurring AMP expenses towards the promotion of their brand. 21.11. At this stage, it is relevant to note sub-section (1) of section 92, which provides that : `Any income arising from an international transaction shall be computed having regard to the arm's length price.' Similarly it is pertinent to take stock of sub-section (3) of section 92, which provides that : `The provisions of this section shall not apply in a case where the computation of income under subsection (1) or the determination of the allowance for any expense or interest under that sub-section, or the determination of any cost or expense allocated or apportioned, or, as the case may be, contributed under sub-section (2), has the effect of reducing the income chargeable to tax or increasing the loss, as the case may be, computed on the basis of entries made in the books of account in respect of the previous year in which the international transaction was entered into. On a careful perusal of sub-section (3) in combination with subsection (1), it transpires that if the computation of income having regard to ALP of an international transaction has the effect of reducing the income chargeable to tax computed on the basis of entries made in the books of account, then the provisions of section92 will be ignored. It can be understood by way of a simple example. If the arm's length price of an international transaction in the nature of expense is `100 and the amount of actual expense recorded in the books of account is `80/-, then the arm's length price of such expense at `100 will be ignored, because acting upon such ALP will lead to lowering of the total income by `20, which isn't permissible as per sub-section (3). If however the ALP of such expense turns out to be lower at `60, then sub-section (1) of section 92 will apply and the total income of the assessee will be computed by considering the ALP of expense at `60, making a northwards sojourn to the total income by `20.
ITA No. 5637/D/2011 3721.12. We have noticed above that sub-section (1) of section 92 read with rule 10B requires computation of income from `an' international transaction having regard to its arm's length price. It means that each international transaction is required to be subjected to the TP provisions distinctly. What is relevant to note on a conjoint reading of sub-section (1) and sub-section (3) of section 92 is that if there are two distinct international transactions and the determination of ALP in respect of the first transaction leads to an increase in total income as per sub-section (1) but no adjustment is called for in respect of the second transaction as per sub-section (3) because of the ALP on the negative side, then the ALP in respect of the first transaction shall be considered in computing the total income, but the ALP of the second transaction shall be ignored. There is no provision which permits set off of negative adjustment with the positive adjustment to the income on account of different international transactions. The outcome of both the transactions has to be given effect distinctly. It, therefore, divulges that two or more international transactions are required to be separately processed under the TP provisions. The contention that if TNMM has been applied on one international transaction, then it would oust the jurisdiction of the TPO to process other international transactions under Chapter-X, really does not stand in the scheme of the provisions. Further, it this contention is taken to logical conclusion, then sub-section (3) of sec. 92 will become redundant to some extent.
21.13. There is one more way of fortifying our above conclusion. TNMM is one of the five recognized methods for determining the ALP of an international transaction. Such ALP can be determined inter alia by comparable uncontrolled price (CUP) method or Cost Plus method or even by the TNMM. All the five methods, as prescribed under section 92(1) and rule 10B, aim at determining the ALP of an international transaction in one way or the other. First is the CUP method, by which the price charged or paid for property transferred etc. in a comparable uncontrolled transaction is identified. Such price is adjusted to account for differences, if any, between the international transaction and the comparable uncontrolled transaction. The adjusted price arrived at is taken as ALP in respect of the property transferred etc. in the international ITA No. 5637/D/2011 38 transaction. In the like manner all the methods including TNMM provide for determining the ALP of an international transaction. The main focus of the ld. AR was on restricting the application of the provisions of Chapter-X to other international transactions when one transaction has been processed under the TNMM. It has been argued so on the ground that under the TNMM, the net profit of the entity is considered which includes the effect of all other transactions also. The natural consequence of the ld. AR's argument on this issue is that if the ALP of an international transaction is determined by the TNMM then no other international transaction can be subjected to the TP provisions.
From here it follows that if any other method, such as CUP or Resale price method etc., is applied for determining the ALP of an international transaction, then the processing of the other international transactions is permissible. The irrationality of the contention can be measured from this factor alone. As all the five methods are aimed towards one end, being the determination of ALP of an international transaction, it is but natural that the consequences of application of each such method qua the other international transactions cannot be varying. It is not possible to hold that if one method is employed for determining the ALP of an international transaction then it is open to the TPO to process other international transactions through the TP provisions, but if some other method is so used, then all other international transactions are immune from such processing. The ld. AR could not draw our attention towards any such provision in the Act. At best, the application of any method including TNMM shows that the said transaction is at ALP. In our considered opinion, the requirement of benchmarking all other international transactions of expenses including AMP, also needs to be scrupulously done, apart from testing one international transaction under the TNMM."
13. Ld. Counsel for the assessee in his written submissions, in reply, has pointed out as under:
"It is submitted that this contention is based on an erroneous understanding of the implications of the LG decision. The Special Bench in LG decision has not mandated ITA No. 5637/D/2011 39 that subsidy should be fully adjusted against the "excess" AMP expenditure. It has held that it needs to be seen whether the value of subsidy received by the assessee in any form (including in the form of subsidy against purchases from AE) is commensurate with the 'excess' AMP expenditure. Therefore, in cases where the value of subsidy exceeds the 'excess' AMP expenditure, the set-off would be limited to the value of 'excess' AMP expenditure so that the value of this transaction gets reduced to Nil. The balance subsidy remaining after the set-off would be available for set-off/adjustment against the other international transaction/s that have to be separately benchmarked. This is shown in the table below:
S.No Nature of Transaction Book Price Arm's LengthPrice Subsidy adjusted Adjustment to the ALP) ALP
1. Import of TV tubes 1,00,000 60,000 10,000 30,000
2. AMP expenditure Nil 20,000 20,000 Nil incurred on brand building Total adjustment 30,000 It can be seen from above, that as per LG decision, out of subsidy of Rs. 30,000 received from the Group companies, Rs. 20,000 would be adjusted towards excess AMP expenditure. Accordingly, the value of 'excess' AMP expenditure would be Nil and no adjustment in respect of AMP expenditure would be warranted. Balance subsidy of Rs.
10,000 will be adjusted towards import price, resulting in an import price of Rs. 90,000. Accordingly, adjustment in respect of import transaction would be Rs. 30,000 (i.e. Rs. 90,000 less ALP of Rs. 60,000).
Alternatively, in case the entire subsidy of Rs. 30,000 is off-set against import transaction, then adjustment in respect of import transaction would be Rs. 10,000 (i.e. Rs. 70,000 less ALP of Rs. 60,000). Further, since no subsidy remains after setting-off the same with import value, adjustment in respect of AMP expenditure would be Rs. 20,000. Thereby, it would result in a total adjustment of Rs. 30,000. Therefore, in either case the amount of adjustment to ALP of the assessee would be same."
14. As regards the CIT(DR)'s contention that the price adjustments obtained by the assessee by way of credit notes should not be taken into account to determine whether the assessee has been adequately compensated by the AE ITA No. 5637/D/2011 40 for the non routine AMP expenditure as there was no formal agreement between the AE and the assessee to the effect that the credit notes were towards compensation for excess or non-routine AMP expenditure, ld. Counsel submitted that this plea has been specifically rejected by Tribunal in BMW's case.
14.1 We have considered the submissions of both the parties and have perused the record of the case.
Applicability of Decision in the case of BMW India Pvt. Ltd.:
15. The assessee has relied on the decision of BMW India Pvt. Ltd. vs. Addl. CIT (ITA No. 5354/D/2012) dated 16th August, 2013. The assessee has filed following additional written submissions to consider the judgment of BMW India P. Ltd. (supra) while deciding the issue relating to AMP on behalf of the assessee:
"Subject: Additional Written Submission to consider the judgment of BMW India Pvt. Ltd. vs. Add!. CIT (I.T.A .No.-5354/DeIl2012) while deciding the issue relating to advertising, marketing and promotion ("AMP") on behalf of the Appellant This is with respect to Motorola Solutions India Private Limited ("MSILP") appeal no. ITA 56371 Dell 2011 for Assessment Year ("AY") 2007-08. The hearings for the same were concluded on July 18, 2013 and the order was reserved on that date. The matter is now awaiting pronouncement of the decision by Your Honours. In the meantime the'!' Bench of the Hon'ble Income Tax Appellate Tribunal ("Tribunal"), New Delhi has pronounced its decision in the case of BMW India Pvt. Ltd. vs. Add!. CIT (I.T.A .No.- 5354/DeI/2012 for AY 2008-09) ("BMW India order"). The said order was passed on August 16,2013. Your Honours attention may kindly be drawn to the following:
As mentioned in the BMW India order, BMW India acted as a distributor of motor vehicles and parts. During the year under consideration in the order, under the Transactional Net Margin method ("TNMM") applied by BMW India its operating ITA No. 5637/D/2011 41 profit margin was higher than the operating profit margin of the comparable companies. During the transfer pricing assessment proceedings, the Ld. Transfer pricing Officer ("TPO"), had alleged that BMW India had incurred excessive AMP expenses vis a vis the comparable companies and therefore, should have been reimbursed by the BMW Group for the excessive AMP spend based on the bright line analysis along with a mark-Up. The Hon'ble Dispute Resolution panel ("DRP") confirmed the additions made by the Ld. TPO.
On appeal by BMW India to the Hon'ble Tribunal, the Hon'ble Tribunal pronounced its decision on various issues related to AMP. As already mentioned above, BMW India was a distributor during the year considered in the order. On these facts, the Hon'ble Tribunal held that this case is distinguishable from the decision of the Special Bench in L.G. Electronics case ("Special Bench") as the fact under consideration in BMW India is the remuneration model of a distributor and not that of a licensed manufacturer. The relevant text of the decision has been provided hereunder: (Para 6.20, page 50 of BMW India order):
Quote On examination of contemporary Guidelines/jurisprudence on the subject, we are of the view that a distributor is rewarded by the entity for whom the distributor works and the rewards are guaranteed upto an extent and the risk component vis-a-vis a manufacturer is necessarily very less. The rewards can be and generally are based on pricing adjustments and can also be compensated over and above that if greater services are rendered and pricing adjustments have not covered the cost of routine services rendered. Generally speaking the remuneration model for a distributor is reward-based and rewards are based on the quantity of sales.
Unquote The second point pronounced by the Hon'ble Tribunal was that during the year under consideration in the order, BMW India's operating profit margin was higher than that of the comparables. The comparable companies set and their margins were not disputed by the Ld. TPO and the Hon'ble DRP. Hence, the Hon'ble Tribunal held that the compensation for AMP services was embedded in the pricing arrangement of the ITA No. 5637/D/2011 42 contract goods itself and that no further compensation was required to be made by the Associated Enterprise ("AE"). In other words, BMW India had received compensation for AMP expenses through premium pricing which was demonstrated through its higher profit margins. The relevant text of the Hon'ble Tribunal ruling in case of BMW India is provided here below(Para 6.25, 6.26 page 53, 55 of BMW India order): Quote We hold that in the facts of the present case the assessee has demonstrated that the compensation for the higher services was embedded in the pricing arrangement of the contract goods itself It is seen that the comparables identified by the assessee and accepted by the TPO as having similar intensity functions have earned profit at the gross and net levels far below the profits both at gross and net levels as achieved by the assessee. In the circumstances as evidenced from record, we are inclined to agree with the submissions advanced on behalf of the assessee that no further compensation was required to be made by the AE as the same has already been received. Thirdly, the Hon'ble Tribunal in BMW India order provided that BMW India was rewarded by price adjustments to earn profits which included the cost of AMP with mark up. It held that the tax department cannot insist that the mode of compensation received by BMW India from its AE necessarily had to be direct compensation and that pricing adjustment was not acceptable.
The relevant text of the Hon'ble Tribunal ruling in case of BMW India is provided here below(Para 6.27, page 56 of BMW India order):
Quote The claim of the assessee has merit as the assessee with the AE can agree to be rewarded/ remunerated by price adjustments to earn profits which include the cost of rendering services with profit. The department cannot insist in the absence of any provision under the Act that the mode of compensation to the assessee by the foreign AE necessarily has to be directed compensation and pricing adjustment is not accepted. Unquote The Hon'ble Tribunal further held that (Para 6.26, page 55 of BMW India order): Quote ITA No. 5637/D/2011 43 In support of the remuneration model of the assessee who is a distributor rewarded by way of price adjustments to ensure profitability upto mutually accepted terms is a well- recognized and well-accepted method for compensating a distributor. Unquote Further, on the issue of the mark up the Hon'ble Tribunal in the BMW India order held as under (Para 6.28, page 58 of BMW India order):
Quote We hold that in the facts of the present case there was no occasion for the AE to further compensate the assessee for the services rendered towards building the brand of the AE as the same already stood factored in the pricing adjustment of the contract goods. As such the occasion to consider the applicability of mark-up does not arise. Unquote The Hon'ble Tribunal, in para no. 6.27 of the BMW India order has also mentioned that the Special Bench has accepted that there are diverse nature of facts, business models and peculiar terms and conditions of different assesses and there cannot be any straight jacket formula.
Applicability to MSIPL As provided in the detailed hearings and submissions provided, MSIPL for the relevant year under consideration also acted as a distributor of mobile handsets, walkie-talkies and telecom equipment. During the year under consideration, under the TNMM analysis the operating profit margin on sales (OP/Sales) of MSIPL was higher than that of the comparable companies. This has been mentioned in para 1 of page 1 of the written submission filed with Your Honours on May 20, 2013 and again on para 5 of page 133 of the written submission filed with Your Honours on May 20,2013. The Ld. TPO did not have any dispute relating to the TNMM analysis conducted by the Appellant. The only dispute was on the matter of AMP expenses. The Ld. TPO based on the bright line analysis held that MSIPL should have been reimbursed by the AE for the excess AMP expenses incurred by it along with a mark-up. The Appellant filed an appeal before the Hon'ble Tribunal. The grounds related to AMP issue are covered in grounds nos. 2.1 to 2.10 and 3. (The details have been mentioned ITA No. 5637/D/2011 44 in para 4-43 of page 2-23 of the written submission filed with Your Honours on May 20, 2013 and again in para 8 of page 133-138 of the written submission filed with Your Honours on May 20, 2013.) In this regard we humbly submit that the decision in case of BMW India order also applies to MSIPL, as the facts of MSIPL are similar to that in the BMW India order. Hence, we humbly submit that the decision rendered in the BMW case has a direct bearing on the AMP issue. This has been summarized as under:
1.BMW India is a distributor of motor vehicles and related parts. MSIPL is also a distributor. Hence, what is relevant for consideration is the remuneration model of a distributor in both the cases.
2.BMW India's operating margin was higher than that of the comparables. Similarly, MSIPL also operated at a higher net operating margin than that of the comparables.
This is demonstrative of the fact that the compensation for the alleged higher services was embedded in the pricing arrangement of the contract goods itself and that no additional remuneration was required from the AEs. In other words, like it has been held in the BMW India order, the compensation for the alleged excess AMP expenses was received through premium pricing which can also be demonstrated through its higher profit margins.
In the BMW India order, the Hon'ble Tribunal has held that the department cannot insist that pricing adjustment cannot be accepted as mode of compensation. Herein, it may be reiterated, that MSIPL has already received the said pricing adjustment through credit notes as a cost credit! purchase price adjustment from its AEs. This has been mentioned in para no 18 of page 11 of the written submission filed with Your Honours on May 20, 2013 and in para 8(1) of page 134 of the written submission filed with Your Honours on May 20, 2013."
15.1 Thus, the main contention of assessee is that remuneration model in case of Distributor towards AMP Expenses is different from the compensation model in case of License Manufacturer. Therefore, before considering the ITA No. 5637/D/2011 45 application of BMW's case to assessee's case, it is necessary that the business profile of assessee's case viz-a-viz BMW's case with reference to LG's Spl. Bench case is to be considered. Admittedly, the decision in the LG's case has been rendered in regard to AMP Expenses and for quantification of AMP Expenses also detailed guidelines have been laid down in the case of LG. 15.2 In case of LG Electronics brief facts were as under:
"The factual matrix of the case is that L.G. Electronics Inc. (hereinafter called as ―LGK‖), is a Korean based company, engaged in the business of manufacture, sale and distribution of electronic products and electrical appliances such as television, audio/video equipments, washing machines, refrigerators and air- conditioners etc. Pursuant to the approval of the Govt. of India, conveyed vide letter dated 29-1-1997, LGK was permitted to establish a wholly owned subsidiary in India. L.G. Electronics India Pvt. Ltd. (hereinafter called as ―LGI‖), that is the assessee in question, was incorporated in 1997 as a wholly owned subsidiary of LGK. An agreement was entered between LGK and LGI on 10th March 1997, as per which both entered into a mutual foreign collaboration agreement. Thereafter a Technical assistance and royalty agreement was entered into between these two entities on 1-7- 2001 by which LGI, in the capacity of a licensee, obtained a right to use the technical information, designs, drawings and industrial property rights for the manufacture, marketing, sale and services of the agreed products from the LGK i.e. the licensor."
16. In assessee's case the factual matrix has been reproduced earlier. Assessee is primarily engaged in the distribution of telecom equipment, mobile phones and provision of telecommunication service in India. The company also provides software development services to the group companies. Additionally the company also provides marketing and administrative support services to its group company. In the case of BMW the factual matrix was as under: ITA No. 5637/D/2011 46
2.4 "A perusal of the same shows that the TPO took note of the facts that the BMW Group has global operations in 3 segments namely Automobiles, Motorcycles and Financial Services. The parent company of the group is BMW AG i.e. the associated enterprise (hereinafter referred to as the "AE") which is headquartered in Munich, Germany and is primarily engaged in the manufacturing of automobiles and motorcycles. The major car brands manufactured by BMW AG are stated to be BMW, Mini and Rolls-Royce. The TPO takes note of the fact that the assessee had undertaken the following international transactions:
S.No Description of transaction Value (in Rs.) Method .
1. Purchase of raw material 167,051,934 TNMM
2. Purchase of traded vehicle 535,438,461 RPM
3. Purchase of spare parts 18,057,016 RPM
4. Purchase of fixed assets 175,346,819 CUP
5. Purchase of software 78,880,000 CUP
6. Receipt of technical support 29,449,506 CUP service
7. Receipt of IT support services 2,739,917 CUP
8. Market survey expenses 11,711,690 CUP
9. Reimbursement of personal cost 17,252,074 CUP
10. Reimbursement of expenses 12,270,724 CUP
11. Interest of loan 12,9773,291 CUP 2.5 Referring to the Transfer Pricing Study of the assessee, the TPO observed that the assessee described its activities as that of a distributor. The TPO referred to the Importation Agreement between the parent company BMW AG and the assessee and observed that the same had been entered into w.e.f. 01.01.2006 and it stated that the assessee had the following duties in regard to marketing and promotion of the products of the parent company:
"2.2. Responsibility in the Contract Territory BMW India represents the interest of BMW AG in the Contract Territory. It is responsible for the sale promotion and the full utilization of the market potential for the Contract Goods in the Contract Territory.
It is further responsible for ensuring the provision of the best possible customer service and adequate stocks of original BMW parts in the Contract Territory. Furthermore, BMW India undertakes the following functions in the Contract Territory in accordance with the laws of the contracting territory:
• Establishment and supervision of an efficient BMW distribution network; ITA No. 5637/D/2011 47 • Performance of an adequate advertisement and sales promotion as well as public and media relations.
• Collection, evaluation and communication of market information to BMW AG.
3. Scope of the Activity of BMW India 3.1 BMW India will meet its responsibility for the promotion of sales and the full utilization of the market potential for the Contract Goods by applying its best efforts and adequate resources toward effective sales promotion and advertising for the Contract Goods including available optional equipment and accessories."
16.1 From the above factual matrix regarding business profile of the three entities under consideration, it is quite evident that business profile of none was identical. As far as BMW's case was concerned, Tribunal held that the same was predominantly a distributor of automobiles with insignificant or low value added assembly functions. Therefore, it was held that the decision in LG's case was not applicable being distinguishable on facts and accepted the assessee's contention that since the remuneration model of the assessee who was a distributor got rewarded by way of price adjustment to ensure profitability therefore, no further addition was required observing as under:-
6.27 "We on considerations of the contemporaneous international jurisprudence which supports the claim of the assessee are of the view that even if considering the arguments of the ld. CIT DR for a moment, the contemporaneous international jurisprudence is ignored even then the claim of the assessee has merit as the assessee with the AE can agree to be rewarded/remunerated by price adjustments to earn profits which include the cost of rendering services with profit. The department cannot insist in the absence of any provision under the Act that the mode of compensation to the assessee by the foreign AE necessarily has to be directed compensation and pricing adjustment is not accepted. In the absence of any such Rule or provision in the Act baring such mode, the assessee is free to adjust and apply any method which it finds most suitable to manage its affairs. Had it been specifically required by the Statute and the Rules thereunder ITA No. 5637/D/2011 48 that the remuneration/compensation for the performance of non-routine functions of a distributor has to necessarily be remitted/reimbursed separately with a cost plus the occasion to refer and rely on the terms of then Importation Agreement would have not arisen as the mandate of the Statute necessarily prevails on the terms of the Agreement entered into between the parties. Similarly reliance on OECD TP Guidelines etc. would then have no relevance. In the absence of any such bar in the Statute and the provision, we do not see any infirmity if in the terms of the Importation Agreement, the assessee for its functions performed beyond the routine functions as calculated by applying the bright-line test has been compensated by the AE by making pricing adjustments so as to ensure that the assessee is left with representative profits after meeting it costs. The fact that assessee's profits vis-à-vis the comparables with similar intensity functions far exceeds the mean margin of the comparable stands established. The contemporaneous international jurisprudence supports this and even the Special Bench leaves the issue open by accepting its limitations while giving voice to the diverse nature of facts, business models and peculiar terms and conditions of different assessee by observing that there cannot be any 'straight-jacket' formula. 6.28 Accordingly after a detailed analysis of the relevant provisions of the Act, the FAR analysis of the assessee, the terms of the Importation Agreement entered into by the assessee with its AE, the orders and judgments relied upon and considered by us in order to decide the issues and weigh the merits and relevance of the comprehensive arguments made at length by both the sides juxta posed with the facts and figures of the assessee in the year under consideration and the comparables as addressed in the orders and referred to by the parties before the Bench, we hold that in the facts of the present case there was no occasion for the AE to further compensate the assessee for the services rendered towards building the brand of the AE as the same already stood factored in the pricing adjustment of the contract goods. As such the occasion to consider the applicability of mark-up does not arise. We further find support from the decision of the Special Bench in L.G. Electronics case which considers a deviance from the view taken in the case of an assessee who incurred higher AMP vis-à-vis the comparables in the initial years. As discussed in the earlier part of this order, the DRP ITA No. 5637/D/2011 49 specifically notes that this is the first full year of assessee's functioning. The TP study referred to by us in the earlier part of this order addresses the prevalent competition in the market and the fact that the sector is highly competitive becomes more so far a new entrant where there is a declining trend seen in the automobile sale market coupled with nentrenched position of early entrants in the sector." 16.2 However, in the present case, we find that unlike BMW's case, the assessee has carried out apart from acting as a distributor, the function of software development services to the group companies and also provided marketing and administrative support services to its group company. Therefore, the decision in the case of BMW, in our humble opinion, is not applicable to the present set of facts.
17. In BMW's case the Tribunal has observed that assessee has performed the functions of sales promotion and advertisement in order to make a dent in the market while performing the functions of a distributor with greater intensity as opposed to a routine distributor. Therefore, this decision is not applicable to the facts of the present case. The Tribunal also took note of the fact that BMW as distributor performed higher functions and undertook to establish distributorship network, advertise, promote and market the brand remuneration/compensation/rewards of distributorship were also guaranteed.
Thus, Tribunal primarily proceeded on the premise that in the remuneration model the compensation for AMP expenses was duly embedded. This aspect in the present case needs to be demonstrated by assessee with reference to global transfer pricing policy, as per factor 9 laid down in LG's case out of 14 conditions in para 17.4.
ITA No. 5637/D/2011 5017.1 However, in any view of the matter, in our opinion the decision of Spl. Bench in the case of LG is applicable to distributors also as is evident from the following observations in LG's case:-
"17.4 In our considered opinion, following are some of the relevant, whose answers have considerable bearing on the question of determination of the cost/value of the international transaction of brand/logo promotion through
1. Whether the Indian AE is simply a distributor or is a holding a manufacturing licence from its foreign AE?"
.............................................................................." 17.2 Thus, it is evident that LG's decision is squarely applicable in the case of all kinds of distributors and the distinction between distributor and an assessee holding a manufacturing license has been made for determination of excess AMP expenses because the considerations between the two differ. Therefore, guidelines laid down therein would govern the determination of ALP of impugned international transaction.
17.3 In view of above discussion, we are of the considered opinion that the decision in the case of BMW has no application to the present case.
18. Ld. Counsel elaborating his arguments submitted that since assessee was earning 5% profit margin as against 1% earned by comparables. Therefore, credit notes received by assessee in pursuance to global transfer pricing policy covers the excess AMP expenses also his contention is that if any further addition is made then it will amount to double addition. We find that Spl. Bench in LG's case has considered this specific plea and has rejected the same ITA No. 5637/D/2011 51 vide para 21.1 to 21.13 of its order noted earlier. We find that while enumerating the 9th factor to be taken into consideration for determination of cost/value of international transaction with reference to AMP expenses, Spl. Bench itself has taken note of the fact that if the compensation has been received for excess AMP expenses regarding brand building then the same is a relevant consideration and this will ensure no double addition as pleaded by ld. Counsel for the assessee. However, the assessee has to establish that in its global transfer pricing policy the AMP expenses had duly been taken into consideration.
18.1 Admittedly, the assessee did not treat the excess AMP expenditure as international transaction and, therefore, it did not form part of TP study submitted by assessee. We find that before TPO the assessee had taken a specific plea to this effect but did not produce any documentary evidence in support of its contention. It is further stated in the above application for admission of additional evidence that DRP never asked the assessee to furnish any supporting evidence in respect of credit notes. After considering the assessee's submissions and taking into consideration the decision of Spl. Bench in the case of LG Electronics India P. Ltd. particularly with reference to guidelines laid down therein with regard to subsidy on the goods sold to the Indian AE , as noted earlier , the benefit of which was not available to either side before TPO or ld.DRP, we are of the opinion that credit notes, now sought to be produced before us, a summary of which has been filed with the application along with sample credit notes, needs to be admitted in order to arrive at correct conclusion in regard to excess AMP ITA No. 5637/D/2011 52 expenditure. We, accordingly, admit the additional evidence. These credit notes needs fresh examination by TPO with reference to fourteen factors particularly factor no. 9 & 10 for determination of the cost of the value of the international transaction of brand/logo promotion through AMP expenses enumerated in para 17.4 of Tribunal's decision in the case of LG Electronics which are as under:
"17.4. In our considered opinion, following are some of the relevant questions, whose answers have considerable bearing on the question of determination of the cost/value of the international transaction of brand/logo promotion through AMP expenses incurred by the Indian AE for its foreign entity :-
1. Whether the Indian AE is simply a distributor or is a holding a manufacturing licence from its foreign AE ?
2. Where the Indian AE is not a full fledged manufacturer, is it selling the goods purchased from the foreign AE as such or is it making some value addition to the goods purchased from its foreign AE before selling it to customers ?
3. Whether the goods sold by the Indian AE bear the same brand name or logo which is that of its foreign AE ?
4. Whether the goods sold bear logo only of foreign AE or a logo which is only of the Indian AE or is it a joint logo of both the Indian entity and its foreign counterpart ?
5. Whether Indian AE, a manufacturer, is paying any royalty or any similar amount by whatever name called to its foreign AE as a consideration for the use of the brand/logo of its foreign AE?
6. Whether the payment made as royalty to the foreign AE is comparable with what other domestic entities pay to independent foreign parties in a similar situation.
7. Where the Indian AE has got a manufacturing licence from the foreign AE, is it also using any technology or technical input or technical knowhow acquired from its foreign AE for the purposes of manufacturing such goods ?
8. Where the Indian AE is using technical know-how received from the foreign AE and is paying any amount to the foreign AE, whether the payment is only towards fees for ITA No. 5637/D/2011 53 technical services or includes royalty part for the use of brand name or brand logo also ?
9. Whether the foreign AE is compensating the Indian entity for the promotion of its brand in any form, such as subsidy on the goods sold to the Indian AE ? 10 . Where such subsidy is allowed by the foreign AE , whether the amount of subsidy is commensurate with the expenses incurred by the Indian entity on the promotion of brand for the foreign AE ?
11. Whether the foreign AE has its presence in India only in one field or different fields ? Where it is involved in different fields, then is there only one Indian entity looking after all the fields or there are different Indian AEs for different fields ? If there are different entities in India, then what is the pattern of AMP expenses in the other Indian entities ?
12. Whether the year under consideration is the entry level of the foreign AE in India or is it a case of established brand in India ?
13. Whether any new products are launched in India during the relevant period or is it continuation of the business with the existing range of products ?
14. How the brand will be dealt with after the termination of agreement between AEs?"
18.2 The main point for our consideration at present is whether assessee is required to establish direct nexus between the AMP expenditure incurred by the assessee and credit notes received from AE. In our opinion, para 17.5 read with paras 21.1 to 21.13 reproduced earlier, of LG's decision, clearly answer this issue. Para 17.5 is reproduced hereunder:
"17.5. In fact, it is the collective effect of the above factors in the comparable case and the case to be compared with, which needs to be kept in view before determining the cost/value of the international transaction. There can be no straitjacket formula for giving weight to each of these factors. What is result of each of such factors in determining the cost/value of international transaction depends on the facts of each case. It is the duty of the TPO to give due regard to such factors by making suitable plus or minus adjustments before finally determining the cost/value of the international transaction." ITA No. 5637/D/2011 54
18.3 In view of above observations read with the observations in paras 21.1 to 21.13 in LG's case reproduced earlier, we are in agreement with ld.CIT (DR) that as per the Spl. Bench decision, it has to be established by assessee that foreign AE was compensating the Indian entity for the promotion of its brand in any form, such as subsidy (credit notes in the present case, as claimed) on the goods sold by the Indian AE. In view of specific observations made, inter-alia, in para no.21.5 of LG's case, we are not inclined to accept ld. Counsel's contention that merely because operating margin to sales is better than the other comparables, it has to be inferred that assessee had duly been compensated towards AMP expenses. In this regard ld. DR's contentions are well founded that each international transaction has to be separately bench marked and overall profitability cannot be a determinative factor as held in LG's case also. Further, in factor no. 10 Spl. Bench has specifically qualified such subsidy for the purposes of adequacy or sufficiency of quantification and this also supports the contention of revenue that the subsidy has to be specifically received for promotion of brand. When specific guidelines have been laid down in Spl. Bench it cannot be held that unless this nexus, though not necessarily one to one, is established, the credit notes can be considered towards excess AMP expenses for brand promotion. However, we agree with ld. Counsel that while determining the Cost/value of the AMP transaction on a stand-alone basis, the direction of Special Bench with regard to the 14 economic and business facts has to be followed. It is mandatory for the TPO to consider all facts and evidence, as may be submitted by the assessee to substantiate that it ITA No. 5637/D/2011 55 had received credit notes/subsidy for projects of goods as per factor 9 and the value of the subsidy so received was commensurate with the expenses incurred by the assessee on AMP as per factor 10. Further, as rightly submitted by ld. counsel, presence or lack of agreements between related parties do not matter much. What matters is the conduct of parties. In this regard it has to be demonstrated by assessee that the global transfer pricing policy of assessee takes into consideration the compensation/contribution towards excess AMP Expenses (brand promotion expenses) incurred by assessee. The OECD guidelines cannot take precedence over the decision of Spl. Bench and, therefore, once the Spl. Bench has held that one of the factors to be taken into consideration is that foreign AE is compensating the Indian entity for the promotion of its brand in any form such as subsidy on the goods sold, then, merely with reference to the overall operating margin of the administrative and marketing division segment, it cannot be held that nexus is not required to be established. There is no gainsaying that decision of Spl. Bench is binding on Division Bench and, therefore, when Spl. Bench has specifically laid down that one of the aspects to be taken into consideration, while determining the cost/value of transaction, is that how foreign AE has compensated the Indian entity for the promotion of its brand then it cannot be held that overall percentage of operating profit may be taken into consideration for holding that credit notes issued by the foreign AE in pursuance to transfer pricing policy were towards the compensation for promotion of its brand. It has to be specifically demonstrated by assessee. One of the contentions of the ld. ITA No. 5637/D/2011 56 Counsel for the assessee is that there is no royalty payment by assessee to its AE. We agree with ld. Counsel that this is a relevant factor which has to be taken into consideration for determination of excess AMP expenditure in the light of LG decision. In our opinion all these aspects need to be examined afresh by TPO.
18.4 In the light of above observations, we restore the matter to the file of ld. TPO for deciding the issue afresh in the light of decision of LG's case after taking into consideration the credit notes, the global transfer pricing policy and other documents to be produced by assessee for substantiating its plea that credit notes were issued by foreign AE towards compensation for promotion of brand.
19. In the result the additional ground raised by assessee is allowed for statistical purposes. Now we will consider the various other grounds taken be assessee with reference to AMP Expenses.
20. Ld. Counsel in the written submissions has first given a brief note on the decision rendered by Spl. Bench in the case of M/s LG Electronics India Pvt. Ltd. vs. ACIT. After considering the same ld. Counsel has fairly conceded that ground nos. 2.1, 2.2, 2.3, 2.6, and 2.9 are covered against the assessee by LG's decision and may be decided accordingly as the assessee reserves the right to prefer an appeal before the Hon'ble Delhi High Court. 20.1 We will, therefore, first in brief refer to the findings of Spl. Bench apropos these grounds.
ITA No. 5637/D/2011 57
21. Apropos ground nos. 2.1 & 2.2, as noted earlier, TPO has disposed off this objection by pointing out that reference had separately been made by AO for determination of arm's length compensation for AMP expenses. . Therefore, these grounds are dismissed.
22. Apropos ground no. 2.3, we find that in para 21.3 to 21.8 in LG's case (SB), reproduced earlier, it has been held that consideration of individual elements of costs (like AMP expenditure) is not inconsistent with TNMM method being accepted at entity level.
22.1 Respectfully following the decision, this ground is dismissed.
23. Ground no. 2.6 is regarding only indirect or incidental benefit to AE and Ground no.2.9 is regarding addition of mark up on the excess AMP expenses. We find that in LG's case in para 23.4 it has been observed as under:
"23.4. It is relevant to note that under second and third steps what is required to be determined is the rate of normal gross profit mark-up as arising to the enterprise from an uncontrolled transaction or to an unrelated enterprise in a similar situation. Here it is significant to note that a comparable uncontrolled transaction to be considered for benchmarking the normal gross profit mark-up has to be similar to the international transaction under consideration. Consequently, the profit mark-up under steps 2 and 3 should in the present case be the rate which an independent third party earns for creating marketing intangible for and on behalf of the foreign enterprise. In the present case, the DRP suggested 13% mark-up. The DRP went wrong in applying steps 2 and 3 by arbitrarily determining the rate of mark-up at 13% without showing as to how much an independent comparable entity has earned from an international transaction similar to one which is under consideration."ITA No. 5637/D/2011 58
24. Respectfully following the decision of Spl. Bench, both the grounds are dismissed.
25. Ground nos. 2.4 and 2.5 are in regard to non-consideration of Group's Global Transfer Pricing Policy pursuant to which AE was compensating the assessee towards excess AMP expenses by way of credit notes. Both these grounds have been discussed In detail while admitting the additional evidence in the form of credit notes filed by assessee. Therefore, both these grounds stands allowed for statistical purposes.
26. Apropos ground no. 2.7, we find that Spl. Bench in the case of LG, while considering the cost/value of transaction, considered the scope of AMP expenses with reference to selling expenses and observed from para 18.1 to para 19 as under:
"Scope of AMP Expenses:
18.1. The ld. counsel for the assessee and some of the interveners contended that the TPO has included selling expenses in the total AMP expenses for the purposes of determining the ALP. It was submitted that selling expenses cannot constitute part of AMP expenses. Our attention was drawn towards the erstwhile sections 37(3A) and 37(3B), in which disallowance u/s 37(3A) was prescribed in respect of expenses referred to in sub-sec. (3A), which, inter alia, included ―advertisement, publicity and sales promotion. It was submitted that various courts have held that the selling expenses cannot be included within the scope of sec. 37(3B). 18.2. The learned Departmental Representative opposed this contention by stating that there is no logic in the contention of the learned AR that the expenses causing sales should be taken out of the total AMP expenses for consideration. All the AMP expenses including the expenses in connection with the sales should be considered as one basket of expenses, out of which the AMP expenses for the creation or promotion of marketing ITA No. 5637/D/2011 59 intangibles on behalf of the foreign enterprise are to be segregated. It was contended that since by their very nature most of the AMP expenses are common having been incurred for own business and brand building for the foreign AE, the reduction of expenses in connection with sales would prejudice the computation of the AMP expenses for the brand building.
18.3. Having heard the rival submissions on this issue, we find that the AMP expenses refer only to advertisement, marketing and publicity expenses. A divider needs to be placed between the expenses for the promotion of sales on one hand and expenses in connection with the sales on the other. Both these expenses are required to be kept in different compartments. While expenses for the promotion of sales directly lead to brand building, the expenses directly in connection with sales are only sales specific. 18.4. Sub-section (3A) of sec. 37, before its omission, provided that where the expenses incurred by the assessee on any one or more of the items specified in sec. 37(3B) exceed one lac of rupees, then twenty percent of such excess shall not be allowed as deduction in computing the income chargeable under the head `Profits and gains of business or profession'. Clause (i) of sub-sec. (3B) referred to ―advertisement, publicity and sales promotion. The Hon'ble urisdictional High Court in the case of CIT Vs. Khetu Ram Bishambar Dass [(2008) 166 Taxman 273 (Del.)], has held that bonus paid to dealers is not in the nature of sales promotion expenses and hence the provisions of sec. 37(3A) cannot be applied to it. The Hon'ble Calcutta High Court in CIT Vs. The Statesman Ltd.
[(1992) 198 ITR 582 (Cal.)] has enunciated that the expenses incurred by way of commission paid to sales agent do not attract disallowance under sub-sections (3A) & (3B) of sec. 37. The Hon'ble M.P. High Court in the case of CIT Vs. Mohd. Ishaque Gulam [(1998) 232 ITR 869 (MP)] has held that the dealer's commission and sales agent commission etc. cannot be brought within the purview of advertisement, publicity and sales promotion expenses, as referred to in sec. 37. 18.5. We do not find any force in the contention of the learned DR made in this regard. The logic in the exercise of finding out the AMP expenses towards creation of marketing intangibles for the foreign AE starts with the expenses which are otherwise in the nature of advertisement, marketing and promotion. If an expenditure itself is not ITA No. 5637/D/2011 60 in the nature of advertising, marketing or promotion, that ought to be excluded at the very outset. We, therefore, reject this contention raised by the learned DR. 18.6. As we are presently considering the term `advertisement marketing and promotion expenses', which is analogous to, if not lesser in scope than the term `advertisement, publicity and sales promotion' as employed in the erstwhile sub-sec. (3B) of sec. 37, all the judgments rendered in the context of sub-sec. (3A) & (3B) of sec. 37 will squarely apply to the interpretation of the scope of AMP expenses. We, therefore, hold that the expenses in connection with the sales which do not lead to brand promotion cannot be brought within the ambit of ―advertisement, marketing and promotion expenses for determining the cost/value of the international transaction.
19. In the facts and circumstances of the present case, it is found that the TPO restricted the comparable cases to only two without discussing as to how other cases cited by the assessee were not comparable. Further it can be seen that the TPO has not considered the effect of any of the relevant factors as discussed above. A bald comparison with the ratio of AMP expenses to sales of the comparable cases without giving effect to the relevant factors as discussed above, cannot produce correct result. It can be illustrated by a simple example. If there is no subsidy in a comparable case but the assessee has received some amount of subsidy from its foreign AE on imports or in any other manner, which fact otherwise needs to be specifically established by the assessee, then the initial amount so computed would require reduction to the extent of such subsidy or vice versa. As the TPO has neither properly considered the request of the assessee for inclusion of some other comparable cases nor examined the effect of the above discussed relevant factors on the question of determination of the cost/value of international transaction, in our considered opinion the ends of justice will meet adequately if the order of the TPO and that of the AO giving effect to such order is set aside and the matter is restored to the file of the TPO for determining the cost/value of the international transaction and the consequent ALP afresh as per law after allowing a reasonable opportunity of being heard to the assessee."
ITA No. 5637/D/2011 6126.1 We, therefore, restore this issue also to the file of TPO for examining the same afresh in the light of LG's decision. In the result this ground is allowed for statistical purposes.
27. Apropos ground no. 2.8 and 2.10 ld. CIT(DR) submitted that the AO/TPO has to redo the exercise in the light of LG Electronics decision. The main dispute is regarding inclusion of Salora International Ltd. and Shyam Telecom Ltd. on the ground that these two comparables were not appropriate for determination of bright line as assessee is principal distributor whereas these two comparables are secondary level distributors. Hence, these two companies do not meet the criteria of comparability as per the Indian TP Regulation. In our opinion, the assessee's contention is deprived of any merit because admittedly these two comparables were selected by assessee itself in its TP report and it is not disputed that they are also distributors. As we are restoring the matter to the file of TPO for deciding the issue in the light of LG's decision, we direct the TPO to carry out fresh search to find out more comparables which meet the criteria of principal distributor also.
28. Apropos ground no. 2.10 the main contention is that the TPO determined the mark up with reference to following five comparables the business description of which was as under:
S.No. Company Business description
Name
1. Rockman Rockman Advertising
Advertising & & Marketing (I) Ltd.
Marketing is engaged in
(India) Ltd. provision of complete
communication
solutions. It is also
engaged in carrying
ITA No. 5637/D/2011 62
out activities related
to film and
documentary
production,
fabrication of
hoardings, etc.
2. Goldmine Goldmine Advertising
Advertising Ltd. Ltd. is engaged in
provision of full-
fledged
communication
solutions, delivering
solutions ranging
from press to
electronic and outdoor
media.
3. Marketing Marketing Consultants
Consultants & & Agencies Ltd. is
Agencies Ltd. engaged in rendering
advertising and
other related services.
4. Needwise Needwise Advertising
Advertising Pvt. P. Ltd. is engaged in
Ltd. Provision of
advertising services.
5. Adbur Pvt. Ltd. Adbur Pvt. Ltd. is
engaged in provision
of
Advertising and
marketing services.
28.1 He, therefore, submitted that the comparables selected are not in
conformity with the decision of LG's case. He further submitted that as far as Rockman advertisement and marketing is concerned the same is engaged in the same business of film and documentary production, fabrication of holding etc. Therefore, this company is in no manner engaged in the provision of brand building or marketing services.
29. Ld. Counsel referred to DRP's order and pointed out that though this fact was brought to the notice of DRP but the same has not been considered. 29.1 We have considered the submissions of ld. Counsel for the assessee. We find that at page 3 of DRP's order it has been, inter-alia, observed as under: ITA No. 5637/D/2011 63
"The other comparable objected to by assessee Rockman Advertisement is found to be comparable by the DRP"
29.2 Therefore, the plea of ld. counsel that ld. DRP has not considered the issue cannot be accepted. Further, we find that TPO at page 205 has referred to the data available on the prowess data base from where he has pointed out that 100% of its revenue was from advertisement activities. However, we find that assessee, while filing its objection before DRP at page 58, had reiterated that company was also engaged in carrying out activities related to film and documentary production, fabrication of holdings etc. It was further pointed out that the company has booked the sales revenue of Rs. 1.4 crore during the said year. As against this, the assessee's alleged excess AMP expenses on which a markup was applied by the TPO was Rs. 158 crores. These objections have not been considered by ld. DRP and the TPO has also relied on the Prowess Data Base. Under such circumstances, we are of the considered opinion that the matter needs to be restored back to the file of TPO for examining the issue afresh in the light of objections raised by assessee. Accordingly, this ground is allowed for statistical purposes.
29.3 In view of above discussion, ground nos. 2.4, 2.5, 2.7, 2.8 & 2.10 are allowed for statistical purposes.
30. Apropos ground no. 3, we find that DRP has already given direction, which has been reproduced earlier, that the two comparables Spice Mobility and General Sales Ltd., are to be included after due verification. The TPO is directed to carry out the direction of ld. DRP.
ITA No. 5637/D/2011 64
31. In the result, this ground is allowed for statistical purposes.
32. Ground no. 4 is with regard to adjustment of Rs. 1055745127/- while re-computing the arm's length price of the international transactions pertaining to Contracts Software Development Service segment. The assessee has challenged this addition on various counts as per ground nos. 4.1 to 4.11. 32.1 As per transfer pricing study submitted by assessee, in the software development segment, assessee performs activities relating to software development/coding relating to party control and documentation, testing, implementation and maintenance. This work was carried out by assessee in accordance with the guidelines provided by the AEs. As per the functional analysis documented in the transfer pricing documentation, assessee characterized itself as a captive service provider claiming that it assumed less than normal risk associated with carrying out such business. Assessee bench marked its SDS segment by applying TNMM as the most appropriate method with operating profit/total cost as the profit level indicator. The assessee had used following quantitative filters in its transfer pricing documentation as contained at page 1019 to 1020 of paper book:
Criteria and reason for usage No. of Companies
Passing the criterion
Total universe of companies available in Prowess as of February 15, 9,801
2007.
Companies with positive sales and ratio of other operating income to 682
sales more than
50% over the time period under consideration were selected so as to capture all Potential comparables within the service industry.
Companies with the ratio of research and development expenses to 669 sales less than or Equal to 3%,were selected. Such comparables do not have ownership of intangibles And are pure service providers.
Companies with the ratio of net fixed assets to sales less than or equal 538 ITA No. 5637/D/2011 65 to 200%, were Selected. Such comparables do not undertake manufacturing or hold substantial Assets, which are not utilized for provision of service. Companies with average sales of more than or equal to INR 1 Crore 484 over the period Under consideration were selected. The companies with low levels of sales may indicate start-up operations or the same persons being both shareholders and key employees, diminishing the economic distinction between profits and salaries.
Companies with net worth more than or equal to zero were selected. 447 Implying that the Companies are in operations.
Companies with the ratio of the sum of advertising, marketing and 340 distribution expenses to sales less than or equal to 3%, were selected. Such comparables do not have ownership of marketing intangibles and are engaged in provision of service. Qualitative (Companies engaged software development activities 11 broadly similar to Those carried out by MIPL in respect of its Class II activities) 32.2 The search process carried out by assessee by applying the aforementioned filters resulted into selection of 17 comparables as under:
S.No. Name of the Data Un-
Company Sou adjus
rce ted
Mark-
up
on
Total
cost
1. Bodhtree P 18%
Consulting Ltd.
2. FCS Software P 14%
Solutions Ltd.
3. Goldstone P 3%
Technologies
Ltd.
4. Larsen & P 11%
Toubro
Infotech Ltd.
5. Melstar P 0%
Information
Technologies
Ltd.
6. Orient P -6%
Information
Technology
Ltd.
7. Powersoft P 19%
Global
Solutions Ltd.
8. SIP P 25%
Technologies
& Exports Ltd.
ITA No. 5637/D/2011 66
9. Sonata P 9%
Software Ltd.
10. Synetairos P 11%
Technologies
Ltd.
11. VJIL P 7%
Consulting Ltd.
12. Akshay C 7%
Software
Technologies
Ltd.
13. Cambridge C 21%
Technology
Enterprises
Ltd.
14. ICRA Techno C 15%
Analytics Ltd.
15. Mindtree C 11%
Consulting Ltd.
16. Computech Seg- 7%
International P
Ltd.
17. Karuturi Seg- 4%
Networks Ltd. P
Mean 10%
33. The assessee earned an operating profit/total cost margin of 7% for its software development services activities. This was computed as under:
Operating Income 6812082673/- Less Total Cost 6350000000/- Operating Profit 462082673/- Operating profit/total cost 7%. 33.1 The assessee pointed out that as per Indian Tax Regulations, it can
choose a price which does not very from the price of comparables by more than 5% (proviso to section 92(2) of the Act). Since the price of comparables was within this range, assessee claimed that the transactions undertaken by it were at arm's length.
34. As against the aforesaid approach of assessee, the TPO adopted the following approach:
a. The TPO rejected the TP Study prepared by the assessee stating that quantitative filters were incorrect; selection/rejection of comparable companies ITA No. 5637/D/2011 67 was based on qualitative filter "functional difference" is not objected and uniform; data for current year is not used; RPT and other filters are not applied and as a result rejected the bench marking analysis conducted by assessee on the basis of several additional quantitative filters selected by him. The defects as highlighted by TPO are reproduced hereunder:
"As per the Rule 10B(4), the data to be used in analyzing the comparability of an uncontrolled transactions with an international transaction shall be the data relating to the financial year in which the international transaction has· been entered into. The word used is "shall", indicating that neither the tax payer nor the TPO has any choice but to use the data pertaining to the FY 2006-07. Earlier year data, in addition to current year's data, can be used only if the conditions mentioned in Proviso to Rule 10B(4) are fulfilled. As can be seen from the TP report that the tax payer has not used at all the data pertaining to the FY 2006-07 in all the 18 comparables. This issue is discussed in detail under the head "Use of Current Year Data". The TP study thus suffers from legal infirmity. This has led to the use of incorrect data.
2.The tax payer has not given any details regarding the application of controlled-party transaction filter. As the tax payer has not at all considered the data for the FY 2006-07 in all the comparable cases, the following companies have been considered as comparables, which otherwise do not pass the tax payer's own admitted filter of RPT less than 15% of revenues.
Name of the Comparable Company Related Party
Considered Transactions as a %
of operating revenue
by the Tax Payer
for the FY
2006-07
FCS Software Solutions Ltd 28.10%
Sonata Software Ltd 38.07%
Cambridge Technology Enterprises
99.94%
Ltd
In fact, the above companies fail the taxpayer's own 15% related party transactions ITA No. 5637/D/2011 68 filter even based on the earlier year data.
3.The taxpayer selected domestic companies such as Synetairos Technologies Ltd, though it is mainly an, export oriented software development service provider,
4.The taxpayer selected companies such as Akshay Software Technologies Ltd, Melstar Information Technologies Ltd, Orient Information Technology Ltd, VnL Consulting Ltd etc. which are: predominantly onsite software companies (generating more than 75% of their export revenues from onsite software development services) rendering services at the site of client or through their branches located outside India whereas the taxpayer is mainly an offshore company delivering all the services through its centers in India.
5.The tax payer has considered companies as comparables even though they are not functionally similar to the tax payer. Some additional filters are applied by the TPO like export earnings filter (companies with export earnings less than 25% of the revenues are rejected as comparables), salary filter (companies in which salary expenses are less than 25% of operating revenues are rejected as comparables), service income filter (companies in which software services income is more than 75% of the revenues were considered as comparable) etc so as to make the comparables functionally similar and also economic circumstances also similar to that of the taxpayer. These filters are discussed in detail under their respective heads in the order.
6.The tax payer has taken companies as comparable even if they do not work in same economic circumstances as that of the tax payer. The comparability study is correct or reliable only if the economic circumstances in which the tax payer is placed are similar to those in which the comparable companies are placed. This is evident from Rule IOB(2), which broadly says that uncontrolled transactions should be judged not only with reference to the specific characteristic of the services rendered by the tax payer (software services), functions performed (FAR analysis), and contractual terms but also with reference to conditions prevailing in the markets in which the respective parties to theinternational transactions operate, including geographical location and size of the market, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition etc. The major ITA No. 5637/D/2011 69 attribute of economic circumstances in comparability was ignored by the taxpayer and thereby, the TPO has to apply additional quantitative criteria such as onsite revenue filter, diminishing revenues filter etc. to make the economic circumstances comparable.
7.Some companies were rejected by the tax payer on the functionality ground / business review in its TP study though they are into software development services or they have software development services segment and qualify all the filters applied by the tax payer based on the data pertaining to the FY 2006-07 and also to the earlier years, in some cases.
8.As discussed below, except two none of the taxpayer's comparable do not stand scrutiny of FAR analysis. The taxpayer itself accepted the rejection of some of the comparables on the ground of RPT, functionally different etc. This itself shows that the comparables were not properly selected and the data used in the TP documentation was neither reliable nor correct.
Due to the above pertinent defects in the Transfer Pricing study, which is not based on Rule lOB, the TP study done by the tax payer was proposed to be rejected uls 92C(3)© r.w.s. 92CA(3)."
The TPO applied following additional quantitative filters while conducting the fresh bench marking analysis:
a. The companies whose data was not available for the F.Y. 2006-07 were excluded;
b. Companies whose software development services turnover was less than 1 crore were excluded;
c. Companies whose software development service revenue was less than 75% of the total operating revenues were excluded unless segmental details were available and the segment qualified this filter.
d. Companies who had more than 25% related party transactions (income as well as expenditure combined) of the operating revenues were excluded; e. Companies which had less than 25% of the operating revenues as export sales were excluded;ITA No. 5637/D/2011 70
f. Companies which had diminishing revenues/persistent losses for the period under consideration were excluded;
g. Companies having different financial year ending (i.e. not March 31, 2007) or data of the company which did not fall within 12 months period i.e. 01/04/2006 to 31/03/2007, were rejected;
h. Companies whose employee cost to operating revenues was less than 25% of the revenue were excluded;
i. Companies whose on-site revenue was more than 75% of the export revenue's were excluded;
j. Companies that were functionally different from that of the tax payer were excluded.
Applying the aforesaid filters, the TPO identified 26 comparable companies which were as under:
1) Accel Transmatic Ltd. (Seg.)
2) Avani Cimcon Technologies Ltd.
3) Celestial Labs Ltd.
4) Datamatics Ltd.
5) E-Zest Solutions Ltd.
6) Flextronics Software Systems Ltd. (Seg.)
7) Geometric Ltd. (Seg.)
8) Helios & Matheson Information Technology Ltd.
9) IGate Global Solutions Ltd.
10) Infosys Technologies Ltd.
11) Ishir Infotech Ltd.
12) KALS Information Systems Ltd. (Seg.)
13) LGS Global Ltd. (Lanco Global Solutions Ltd.)
14) Lucid Software Ltd.
15) Mediasoft Solutions Ltd.
16) Megasoft Ltd.
17) Mindtree Ltd.ITA No. 5637/D/2011 71
18) Persistent Systems Ltd.
19) Quintegra Solutions Ltd.
20) R S Software (India) Ltd.
21) R Systems International Ltd. (Seg.)
22) Sasken Communication Technologies Ltd. (Seg.)
23) SIP Technologies & Exports Ltd.
24) Tata Elxsi Ltd. (Seg.)
25) Thirdware Solutions Ltd.
26) Wipro Ltd. (Seg.)
35. Ld. DRP directed the TPO to exclude two comparable companies viz Persistent Systems Ltd. & Mega Soft Solutions Ltd. After receiving the directions of ld. DRP, the AO only excluded Persistent Systems Ltd. and computed the arm's length profit margin at 23.90 as under:
Name of the Working Working
Company Capital Capital
adjusted adjusted
OP/TC OP/TC
As per After the
Original directions
Transfer of
Pricing Hon'ble
Order DRP-1
Accel Transmatic 21.07% 21.07%
Ltd. (Seg.)
Avani Cimcon 49.91% 49.91%
Technologies Ltd.
Celestial Labs Ltd. 55.26% 55.26%
Datamatics Ltd. 0.62% 0.62%
E-Zest Solutions Ltd. 36.63% 36.63%
Flextronics Software 26.17% 26.17%
Systems Ltd. (Seg.)
Geometric Ltd. 10.80% 10.80%
(Seg.)
Helios & Matheson 35.51% 35.51%
Information
Technology Ltd.
IGate Global 6.82% 6.82%
Solutions Ltd.
Infosys Technologies 40.03% 40.03%
Ltd.
Ishir Infotech Ltd. 31.50% 31.50%
KALS Information 24.55% 24.55%
Systems Ltd. (Seg.)
ITA No. 5637/D/2011 72
LGS Global Ltd. 16.33% 16.33%
(Lanco Global
Solutions Ltd.)
Lucid Software Ltd. 2.80% 2.80%
Megasoft Ltd. 52.32% 52.32%
Mindtree Ltd. 16.52% 16.52%
Persistent Systems 24.22% Excluded as
Ltd. per
directions
Of the
Hon'ble
DRP
Quintegra Solutions 10.42% 10.42%
Ltd.
R S Software (India) 14.31% 14.31%
Ltd.
R Systems 14.42% 14.42%
InternationalLtd.
(Seg.)
Sasken 22.22% 22.22%
Communication
Technologies Ltd.,
(Seg.)
SIP Technologies & 11.89% 11.89%
Exports
Ltd.,
Tata Elxsi Ltd., 27.30% 27.30%
(Seg.)
Thirdware Solutions 22.66% 22.66%
Ltd.,
(Seg.)
Wipro Ltd., (Seg.) 35.36% 35.36%
Mean 24.15% 23.90%
35.1 He, accordingly, made a transfer pricing adjustment of Rs.
1055745127/- as under:
Particulars Amount in INR
Operating cost of the 6,350,000,000
assessee under CSD
Segment (A)
Add: Mark-up @23.90% 1,51,78,27,800
(as per Hon'ble
DRP's directions)
(B) = (A*23.90%)
ALP of CSD segment (C) 7,86,78,27,800
= (A) + (B)
Price charged in the Rs. 6,812,082,673
international
Transactions
Shortfall Being Rs. 1,05,57,45,127
adjustment u/s 92CA
ITA No. 5637/D/2011 73
35.2 In the backdrop of aforementioned facts, the assessee has assailed
the assessment order on various grounds with reference to Software Development Service Segment noted earlier.
Before we consider separate grounds, we reproduce the submissions of ld. CIT(DR) which would be relevant for different grounds Miscellaneous
1. The power of TPO to make inquiries u/s 133(6) has been okayed in a plethora of cases. Even if the information gathered u/s 133(6) is at variance with published annual report, information obtained by TPO u/s 133(6) is to be considered more authentic. (Pl. see para 72 of the order of M/s Trilogy E-Business Software (I) P. Ltd., ITA No. 1054/Bang/2011, A.Y. 07-08, dtd. 23/11/2012. Para 47 of this order is at variance with para 72).
2. In a mean situation, transactions are evened out. Quark Systems (SB). Para 25. Assessee's own case.
3. OECD need not be relied upon, when we have our own legislation and jurisprudence on the issue. Support is found from Hon'ble Delhi High Court in the case of M/s CIT vs. Mentor Graphics (Noida) P. Ltd., ITa No. 1114/2008, dtd. 04/04/2013, para 25 thereof.
ITA No. 5637/D/2011 74
4. In case of ITES (and logically IT) situation, even 40% margin is compared as normal. (M/s Nextlink India P. Ltd., ITA No. 454/Bang/2011, dtd. 19/10/2012, para 40.
5. There cannot be a situation of loss, in a cost plus situation, like the assessee which is getting remunerated at Cost + 7% para 85 of M/s SAP Labs, 418/Bang/2008.
6. Some of the assessee's comparables have been found to be comparables in other case laws. For eg: - the assessee has pleaded that M/s Celestial Labs Ltd. is not acceptable as per his case law M/s Tevapharma P. Ltd. 6623/M/2011, dtd. 23/12/2011, para 5 on pages 29 and 30. But in another case law relied upon by him for another proposition (M/s Telecordia Technologies ITA No. 7821/M/2011), para 6.3, page 9, Celestial Labs Ltd., has been found to be comparable.
7. The ITAT order of M/s Philips Software Centre P. Ltd. ITA No. 218/Bang/08, has been stayed by Hon'ble Karnataka High Court. Hence, reliance on this ITAT order, by the assessee is misplaced.
8. The assessee gets remunerated at a lowly cost +7%.
9. The assessee has not established as to how do software product companies differ from other Software companies, ITA No. 5637/D/2011 75 in terms of FAR analysis. Even the assessee had not relied upon Product company as a distinguishing factor.
10. Any adjustment has to be supported by robust data and correlation needs to be established, by empirical evidence.
11. The TPO has used current year data only, for working out the mean. Data of earlier years has been used for working out the trend only. The assessee is trying to mislead on this issue.
12. The powers u/s 133(6) need to be used by the TPO. The only fetter is that the data so obtained is to be shared with the assessee in case it is proposed to be used against the assessee.
The power of TPO to make inquiries u/s 133(6) has been okayed in a plethora of cases.
Even if the information gathered u/s 133(6) is at variance with published annual report, information obtained by TPO u/s 133(6) is to be considered more authentic. (Pl. see para 72 of the order of M/s Trilogy E-Business Software (I) (P) Ltd., ITA No. 1054/Bang/2011, A.Y. 2007-08, dtd. 23/11/2012. Para 47 of this order is at variance with para 72).
Support is found from • M/s Wills Processing Mumbai Order, 8722/Mum/2010, dtd. 07/12/2012, para 26 thereof.
• M/s Actis P. Ltd. 5277/D/11, para 37.
ITA No. 5637/D/2011 76• M/s Trilogy E Business Software India P. Ltd. ITA No. 1054/Bang/2011, para 21 and 22, and para 72. This is assessee's own case law.
• In the case of M/s Headstrong Services India P. Ltd., ITA No. 5466/D/2011, dtd. 17/07/2012, para 40, the use of powers u/s 133(6) by TPO has been okayed. This case is only for purposes of mentioning, not being part of main submission.
13. Even abnormal circumstances need to be examined, whether they have the ability to impact, FAR analysis, M/s Trilogy E Business Software India P. Ltd. ITA No. 1054/Bang/2011, para 36. (This is assessee's own case law), is being relied upon.
14. Assessee's own comparables were mixed up in terms of Functions, products, risk, entrepreneurship etc. The entities which were not captive, had already suffered costs which had impacted their respective profit and loss accounts. In fact the assessee, a captive, by not incurring these costs was at an advantage.
15. To start with, assessee's own benchmarking margin at cost +7% was far below its own self determined Arm's Length Margin of cost +10%.
ITA No. 5637/D/2011 77
16. Every proposition sought to be laid down by the assessee needed to be correlated by empirical data. The assessee failed to do so."
36. At the time of hearing, ld. Counsel for the assessee, did not press ground nos. 4.1, 4.4, 4.5.1 & 4.5.2, 4.5.7, and 4.5.8. Therefore, these grounds are dismissed as not pressed.
37. Apropos ground no. 4.2, the reason for rejecting the use of multiple year data has been noted in the defects highlighted by TPO. The assessee's contention is that TPO has utilized the data for earlier years also while examining the trend of companies incurring losses. Therefore, the multiple year data should have been used for computing the average margin also. 37.1 Having heard both the parties, we do not find much substance in the argument of ld. Counsel for the assessee because as per Rule 10B(4),the data to be utilized and for analyzing the comparability of uncontrolled transaction with an international transaction is to be the data relating to the financial year in which the international transaction has been entered into. As per proviso to Rule 10D, earlier year data can be used, in addition to the data pertaining to the relevant financial year, only for taking a decision as to how much the factors obtaining in earlier years impact the profit of the current year, for both the tax payer and the comparable. Therefore, as rightly submitted by ld.CIT(DR), it has to be demonstrated as to how the earlier year conditions have influenced the profit of the relevant financial year. Since assessee had not given details in this regard, therefore, the TPO's action was justified on this count. At pages 17 to ITA No. 5637/D/2011 78 19, the TPO has given various judicial pronouncements holding that only current year data has to be used for carrying out transfer pricing analysis. Ld. Counsel has very fairly conceded that this issue stands decided against the assessee in numerous cases (Mentor Graphics (Noida) Pvt. Ltd. 109 ITD 101 Delhi, Customer Services India Pvt. Ltd. v ACIT 30 SOT 486. 37.2 In view of above discussion, we do not find any reason to interfere with the order of AO/TPO on this count.
38. In the result, this ground is dismissed.
39. Vide ground no. 4.3 the assessee submits that since it was entitled to tax holiday u/s 10A/10B of the Act on part of its profit from CSD services and, therefore, had no motive of deriving a tax advantage by manipulating transfer prices of its international transactions. In this regard it may be pointed out that the computation of arm's length price is to be done as per the provisions contained under Chapter X of the I.T. Act dealing with special provisions relating to avoidance of tax. Merely because assessee was entitled to tax holiday u/s 10A/10B of the Act, it cannot be inferred that international transaction has been entered into as per arm's length price. There is nothing u/s 10A/10B which entitles an assessee to get deduction in respect of addition made under Chapter X. Ld. Counsel for the assessee fairly concedes that this issue stands decided against assessee by Tribunal in few cases including Aztec Software v ACIT 294 ITR 32(SB).
We, therefore, do not find any substance in the ground raised by the assessee.
40. In the result, this ground is dismissed.
ITA No. 5637/D/2011 79
41. Ground No. 4.5 Rejecting the comparability analysis in the TP documentation/assessee's fresh search and in conducting a fresh comparability analysis based on application of the following additional/revised filters in determining the ALP for the CSD segment:
In this regard Ld. CIT (DR) has submitted as under.
1. Data upto the date of assessment is allowed to be used by the TPO, and the TPO is allowed to carry out a fresh search.
The following case laws are being relied upon:
i. M/s Mentor graphics - Hon'ble Delhi High Court in ITA No. 1114/2008 dated 04/04/2013, for the proposition that a TPO, can carry out a fresh search.
ii. M/s Aztec Software & Technology Services Ltd. (2007) 294 ITR (AT) 32, page 130 thereof.
iii. M/s Symentec Mumbai, ITA No. 7894/M/2010, A.Y. 2006-07, para iv. M/s ST Micro Delhi [15 ITR (Trib)410 Del], para 28 till 32 of this order. [ITA 1806/1807/Del/2008, order dtd. 03/06/2011]. v. M/s Deloitte Consulting Hyderabad ITA No. 1082/1084 of 2010 (paragraph 30 thereof).
vi. M/s Customer Services (I) (P) Ltd. (2009) (30 SOT 486 - Delhi). Fresh search has been approved by TPO in the aforesaid cases.
42. Ld. counsel for the assessee did not seriously disputed the submissions of ld. DR. This ground is dismissed.
ITA No. 5637/D/2011 80
43. Vide ground no. 4.5.3 the assessee has assailed the TPO's action in excluding companies with diminishing revenues/persistent losses for last three years upto and including F.Y. 2006-07. Ld. TPO excluded the companies with consistent losses on the ground that in an environment where software sector was growing at a CAGR (Compound Annual Growth Rate) of more than 30% during the last 10 years or at least for the last three years, the company incurring consistent losses cannot be taken as a representative of the industry. The assessee's contentions were as under:
• The loss making companies are as much a part and parcel of an industry as are profit making companies;
• The arithmetical mean is a scale tendency and loss making companies would introduce skewness in the set of comparables that would result in higher mean margin;
• The retention of loss making companies along side profitable companies tends to even out the risk profile of comparable companies; • If loss making companies are to be eliminated on the ground of previous year losses, then for other profit making companies, previous year average financial data should also be taken into account rather than single year financial information;
• The TPO should restrict the functional and financial data comparability only to the data of the relevant financial year. The TPO's approach by applying criteria favorable to the revenue would be prejudicial to the interest of the tax payer.
44. The TPO did not accept the assessee's contention for the following reasons:
• A company whose performance is extremely divergent from the normal industry trend cannot be considered as a normal comparable. On the face of it, the contrary behavior ITA No. 5637/D/2011 81 of the particular company is indicative of some peculiar facts and circumstances of that company which lead to such divergent behavior.
• The OECD guidelines say that except in start-up situation, loss companies generally will not be appropriate comparables for controlled companies, because they obviously have borne more risk than controlled companies normally are expected to bear. • The loss making comparables may perform same functions, using greater assets, and/or assuming greater risks than the tested party, therefore, persistent loss observed in the proposed comparables understate those that would be expected in the tested party.
• The taxpayer's argument is that arithmetical mean is a central tendency and thus, loss making companies should also be considered. In this regard, it is very pertinent to mention here that the TPO did not exclude loss making companies. He excluded only persistent loss making companies. The comparability exercise cannot be relaxed just to get a loss making company as a comparable.
• The taxpayer's argument that the retention of loss making companies alongside profitable companies tends to even out the risk profile of comparable companies is also far fetching. If the risk of a comparable company is very high, the same is not comparable as the taxpayer and other comparable companies are not assuming that extreme risk resulting in persistent losses. As mentioned above, just because mean takes care of diffences in risk, every loss making software development company cannot be considered as a comparable if it has persistent loss arising due to the peculiar economic circumstances with its greater assets than the tested party. Therefore, persistent losses observed in the proposed comparables understate those that would be expected in the tested party.
• The tax payer argued that the TPO has used the multiple year data for his comparability study, whereas, the tax payer has been denied using the multiple year data while computing the mean ALP. In this order, multiple year data has been used only to find out whether the comparable company is persistently in losses year after year. Apparently the taxpayer has confused use of multiple year data for functional analysis of a comparable with use of the same for working out the arithmetical mean ITA No. 5637/D/2011 82 PLI. Once a comparable company is selected, its margin of the relevant financial year only is considered for determining the PLI. Therefore, there is no inconsistency in use of multiple year data to examine the comparability of a company and once the company is found comparable, only its current year's PLI has been considered. It is only to see the functionality and the peculiar features of a comparable so as to know whether the comparable is operating in comparable (economic) circumstances. This issue has been dealt by ITAT, Delhi Bench in the case of Sony India (P) Limited vs. DCIT, (114 ITD 448) as under in favour of the revenue.
"Godrej in the first place is making refrigerator and not TVs. Secondly, it has suffered huge losses over a period of several years. It has recorded negative growth as admitted at page 6 & 7 of its annual report for F.Y. 2000-01. It had huge unutilized capacity. It needs financial restructuring. It is carrying on disputes on account of demands raised by Punjab Small Scale Industries and Export Corpn. Ltd., apart from the disputes made by its employees for increased wages, reinstatement or termination and suspended employees. The joint venture of the company stands terminated. All this is admitted in the official report of Godrej. Besides, it is also carrying on related party transactions. Each of above factors which is considered and highlighted in the annual report, may not have a significant effect, if taken singly. However, when cummulative effect of all the factors is considered, one gets a totally different picture. It has therefore to beheld that Godrej was rightly excluded from the list of the comparables. We concur with the view taken by the revenue authorities and reject all the arguments advanced by ld. Counsel for the taxpayer. This ground of appeal is rejected."
As mentioned above, the persistent losses filter is a tool to see the exceptional circumstances in a comparable company.
Thus, in summary, the TPO has not excluded loss making cases. TPO has excluded only those companies which incurred persistent losses over a period of three years. This stand has been approved in the judicial pronouncements in the case of Quark Systems Pvt. Ltd. 2010-TIOL-31-ITAT-CHD-SB and Sony India Ltd. 114 ITD 488 (Del) wherein the rejection of comparables having persistent losses, diminishing ITA No. 5637/D/2011 83 revenue, restructuring, etc. was upheld. In fact in the recent decision of the Hon'ble ITAT Bangalore in the case of SAP Labs Ltd., the ITAT has removed all comparables that had a loss in the relevant financial year. The TPO has only removed comparables that are persistent loss makers."
45. The assessee filed objections before DRP. Ld. DRP after considering the assessee's objections, confirmed the TPO's action. Ld. DRP also referred to revised OECD Guidelines, 2010 which also supports this instance. They referred to para 6.63 which state that where one or more of the comparables have extreme results, further examination would be needed to understand the reason for such extreme result. Further in para 3.64 it is stated that an independent enterprise would not continue loss generating activities unless it had reasonable expectation of future profit. In para 3.65 it is stated that a loss making uncontrolled transaction should trigger further investigation in order to establish whether or not it can be a comparable. Circumstances in which loss making transactions/enterprises excluded from the list of comparables include cases where losses do not reflect normal business condition, and where the losses incurred by the third parties reflect a level of risk that is not comparable to the one assumed by the tax payer in its controlled transactions. It is clarified by the OECD Guidelines that loss making comparables that satisfied the comparability analysis should however, not be rejected on the sole basis that they suffer losses. Ld. DRP pointed out that since TPO has individually examined each of the comparable, looked into the economic circumstances as to why such comparable was incurring losses and ITA No. 5637/D/2011 84 confirmed the same with economic circumstance of the tested party, that is the assessee, therefore, the TPO had appropriately applied this filter.
46. Ld. Counsel for the assessee submitted that this filter is not an appropriate filter to be applied for the purpose of comparability analysis for the following reasons:
1. the company is judged as comparable or otherwise based on parameters relating to functions risks and assets. The comparability analysis as per law has to be in accordance with Rule 10B(2) of the Income Tax Rules.
2. Diminishing revenue does not mean that a company is functionally not comparable. Further reasons of diminishing revenue should be investigated and in case any abnormal factor is found to be present then the company should be excluded from the list of comparable company.
3. Ld. TPO has considered the data for previous three years to apply this filter of diminishing revenue. Thus, there is a complete contradiction in TPO's own approach of using only current year data as per Rule 10B(4).
4. The TPO has rejected the companies with diminishing revenue but accepted companies with abnormal revenue trend, such as Avani Cimcon Technologies Ltd., Helios & Matheson Information Technology & Lucid Software Ltd. which has shown more than 60%, 50% & 65% growth in one year respectively. Thus, TPO has been selective in his approach. The TPO's reasoning that companies incurring persistent losses are moving contrary to the growing market is not correct because the average rate of growth of the market is average of rates of growth across the industry which includes all types of ITA No. 5637/D/2011 85 companies and companies that grow much faster than the average, companies which grow much lower than the average and companies that grow close or around the average. The rational of taking the arithmetic mean or the average as the arm's length rate is based on this principle. Exclusion of low or loss making companies makes the average margin artificially screwed to the project of the assessee because while the comparables at the lower end of the range are excluded those at the higher end were left untouched. Ld. counsel pointed out that auditors certify a company as sick in the audit report if the losses are very high, therefore, the annual report of such companies should be analyzed before rejecting them. Margin cannot be starting point of determination of arm's length margin but it is the end result of a careful process of functional and economic analysis provided under law. The assessee relied on following case laws:
S.No. Name of the case Relevant extract form
the case law
1. Trilogy E business It has been held that
India Software P. Ltd., profit/loss
ITA No. should not determine
1054/Bang/2011 Para the functional
35 comparability and the
specific reasons
of lack of
comparability should
be
brought out.
2. Exxon Mobil Co. India If a loss making
P. Ltd., ITA No. company is to be
8311/Mum./2010 para excluded
33(xi) Then on the same
principle abnormal
profit
Making company
should also be
excluded.
The reasons for
rejecting the
comparable
Company should not
be just loss making
Rather their functional
ITA No. 5637/D/2011 86
comparability.
Thus, the reasons for
rejection should
Clearly be brought
out.
3. Quark Systems The Tribunal held
Private Limited, 32 that......"it is obvious
TTJ 1 that
(SB) (Chd.) para 25 The very rationale of
having average in
Case of more than
one transaction is to
Iron out the effect of
extreme cases in
Finding the profit
margin as a
Representative of the
whole lot."
47. Ld. (CIT) DR submitted that persistent losses depicts existence of abnormal circumstances. Ld. DR further referred to page 321 of appeal set (page 53 of transfer pricing officer's order), wherein TPO has summarized his conclusion on this issue, noted earlier.
47.1 Ld. DR further clarified that data for last three years has not been used to work out the mean but to work out the trend. He submitted that only one year data has been used for computing arithmetic mean. Ld. DR further pointed out that in software industry there is no installed capacity but the activity is personal extrinsic. The persistent losses in such an industry is an indicator of assessee not utilizing its full capacity, which is an abnormal factor, making the company non-comparable. Ld. DR further clarified that loss making companies and persistent losses making companies are two different aspects and it is only the persistent loss making companies that have been excluded by TPO. 47.2 Ld. CIT(DR) submitted as under:-
ITA No. 5637/D/2011 87
Exclusion of companies with diminishing revenues/persistent losses for last three years upto and including F.Y. 2006-07.
Counter:
It is submitted that only current year's data has been used for working out the mean. Earlier year's data has been seen, only to work out the trend, since revenue is using the filter of diminishing revenue/persistent losses. It is made clear that data of earlier years has not been used to work out the mean.
(Pages 51 till 55 of TPO's order have elaboration of this issue) The case laws in support are i. M/s Actis Advisers (P) Ltd. Delhi - 5227/Del/2011, (Paragraph 22) ii. M/s Brigade Global - 1494/Hyd./2012, A.Y. 2004-05 (Para 26 last 4 lines) iii. Filter of rejection of persistent losses okayed in M/s CRM Services (I) (P) Ltd. 4068/4796/Del/2010, dtd. 30/06/2011 (paras 13, 13.1 and 13.2) iv. These filters have also been okayed in M/s Quark Systems 4 ITR (Trib.) 606.
v. M/s Sony India P. Ltd. vs. DCIT - 114 ITD 448 (Internal page 54 of TPO's order) vi. Navisite India Pvt. Ltd., ITA No. 5329/Del/2012 dated 31st May,2013."
ITA No. 5637/D/2011 88The assessee has tried to sidetrack the issue by bringing in issue of volatility of margins and extreme results.
This is not the case here.
48. Ld. Counsel in the rejoinder submitted that the decisions relied upon by ld.CIT(DR) are distinguishable and made following submissions:
"48. The decision of Sony India v. DCIT (114 ITO 448) supports the case of the appellant. In this case the Hon'ble ITAT held that a persistent loss making company like Godrej has to be excluded from the list of comparables not because it was making losses but there were numerous factors demonstrating extraordinary economic circumstances (like labour issues, financial restructuring and huge unutilized capacity). Please refer to Page 322 of the Appeal (internal page 54 of the TP order) where the Ld. TPO has reproduced the relevant extract from this decision.
49.Similarly, the Special Bench decision of Quark Systems 32 TTJ I also supports the assessee's contention that just because a company is making loss it cannot be excluded. If the loss is on account of normal business reasons such an exclusion is not permissible. This case was relied upon by the Hon'ble ITAT in Brigade Global ITA 1494/Hyd/2010 which has been cited by the Ld. CIT (DR) (Para 26 of this ruling). The holding in this case is in favour of the assessee.
50.The reliance on the Actis Advisers Pvt Itd ITA 5277/0eI/20 II (Para 22) is again misplaced as the issue in this case, as is evident from the reading of Paras 2 I and 22 of the order, was the justification of including a particular comparable Maple E-Solution which had wildly fluctuating margins ranging from loss of 100% to profits of 37.38%. The Hon'ble ITAT was not adjudicating the applicability of a filter of diminishing revenue or persistent losses at a general level but only in respect of a particular comparable.
51.Similarly, reliance on CRM Services India Pvt. Ltd. ITA No. 4068/0e1/2009 is also of no assistance to the Revenue as the issue in this case was inclusion/exclusion of a ITA No. 5637/D/2011 89 particular comparable whose capital base had been eroded due to persistent losses. (Please refer to Para 13.2 of the order). The question of suitability of the filter of persistent losses or diminishing revenue was not before the Hon'ble ITAT.
52.The industry is an average of both high and low profit earning companies. Further in the search process undertaken by the Ld. TPO 51 out of a total of 765 companies showed diminishing revenue which is approximately 7% of the industry selection made by the TPO. This means if he eliminates companies with diminishing revenue then he is eliminating 7% of the total population of the comparables
53.The sweeping generalization that persistent losses show some abnormal economic circumstances is based on conjectures. There is no such economic principle or correlation that can be substantiated. Incidence of loss usually arises due to market forces - competition, emergence of new technology or processes, increase in costs, variation in demand and supply - and these are all normal economic factors which impact all industry players. It is just that some companies are better able to respond to these factors than others which leads to a situation where some companies makes profits while few others make losses. Only diminishing revenue or consistent losses cannot be termed as abnormality in any industry. For the purpose of choosing comparables, one has to look at the factors of comparability provided in Rule 108(2) - which are characteristics of goods and services; functions, assets and risks; contractual arrangements; and characteristics of the market etc .. Declining revenues and persistent losses are not factors of comparability but merely manifestations of a company's ability to respond to the market conditions.
54.Further final comparable companies selected by the TPO, in his TP order, do not show a uniform trend. It has been highlighted by the Appellant that many of the companies selected by Id. TPO have witnessed a decline in revenue in the future years while they have retained healthy profit and are functionally comparable. If the filter of diminishing revenue was to be accepted then it would lead to an anomaly that a company may be comparable in one year but not in the other despite no change in the functional profile.
55.The Ld. CIT (DR) is of the view that data for multiple year is used only for working ITA No. 5637/D/2011 90 out the trends and not to compute the margins of the comparable companies. Herein the Appellant would like to highlight Rule 10B(4) which states as below:
"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"
56.It is quite evident from the above that the data used for comparability analysis should be that of the current financial year. The Ld. TPO has in this case considered the revenue and loss trend of earlier years in order to determine the comparability which is not in accordance with the said rule. A bare perusal of Rule 108(4) makes it clear that the contention of the Ld. CIT DR, that earlier year data is used only for the purpose of computing mean, is not tenable.
57.Further the Appellant wishes to highlight that the business cycle for any company starts from a trough (lower point) and passes through a recovery phase followed by a period of expansion (upper turning point) and prosperity. After the peak point is reached there is a declining phase of recession followed by a depression. Again the business cycle continues similarly with ups and downs.
58.Thus, every company would be in a different phase of business cycle at a given point of time and thus elimination of a company based on the revenue/profit would not be correct.
59.On the issue of underutilization of capacity as pointed out by the Ld. CIT DR, the Appellant wishes to submit that a declining sales would not always mean an underutilization of capacity. Increase or decrease of sales can be because of increase or decrease of hourly rates charged by the software companies due to variation of demand and supply. Furthermore, in the software industry capacity can be increased or decreased quite quickly depending upon market needs because recruitment or retrenchment of software personnel can easily be carried out. This is well-known industry practice of this sector. It is for this reason that decrease in sales need not necessarily lead to decrease in profit margin - because loss ITA No. 5637/D/2011 91 in revenue is matched by planned reduction of corresponding cost arising from retrenchment of excess work-force. So in these cases when there is a decline in sales the corresponding costs also come down, and as contended by Ld. ClT DR it is not necessary that declining sales would always have an adverse effect on profitability. In this regard, the Appellant places reliance on the ITAT ruling of Capgemini India Pvt. Ltd. ITA no. 7861/Mum/2011.
60.In order to substantiate our point we wish to highlight some of the companies rejected by the Id. TPO on declining sales filter which have actually witnessed an increasing trend in profit during these years Com OP/OC margins Sales in crores pany 2 2 2 2 2 2 Nam 0 0 0 0 0 0 e 0 0 0 0 0 0 4 5 6 4 5 6
- - - - - -
0 0 0 0 0 05 6 7 5 6 7 Mas N 1 3 N 1 1 con A 2 3 A 8 4 Glob . . 1 0
al 2 8 . . Ltd. 1 2 7 7 % % 5 1 Pent 6 7 8 5 1 9 asoft . . . 5 6 . Tech 9 5 2 . . 4 nolo 6 1 5 9 1 5 gies % % % 4 7 Ltd. [Me rged ]
Thus, there is no correlation between decline or increase in sales and the margins." 48.1 We have considered the rival submissions and have perused the record of the case. The TPO had excluded the companies with diminishing revenue because in an environment where software sector is growing at a CAGR (Compounded Annual Growth Rate) of more than 30% during the last 30 years, diminishing revenue for the last 3 years cannot be said to be a true indicator of the performance of the company. In this regard we find that TPO ITA No. 5637/D/2011 92 had undertaken an independent analysis which was based on various sources including NASSCOM Reports, articles appearing in print media and on the internet etc. It was found that during the last decade the information technology industry in India emerged as an important constituent of the global software industry. The following important aspects were noticed in this regard:
• The Indian IT Industry is broadly categorized into IT Services and Software, ITES/BPO and Software Segment;
• The Indian IT Industry stood at US 37.5 million dollars in F.Y. 2005-06 and US 48 billion dollars in F.Y. 2006-07 in terms of revenue, translating into a growth rate of 28% y-o-y • The total IT Industry contribution to the Indian GDP had increased from 1.4% in 1998-99 to 5.4% in 2006-07 with growth rate of about 30% (Source Ness com);
• The exports contributed around 66% of the total Indian IT Industry; • The key segments that have contributed significantly (about 98%) to the export growth are ITS & ITES.
49. All this statistical data clearly demonstrate that IT Industry was growing with rapid pace and, therefore, the argument advanced by TPO cannot be faulted. As far as assessee's contention regarding contradictory stand adopted by TPO in not considering the persistent loss making companies based on earlier year's data but taking into consideration the current years data for computing the mean is concerned, we do not find any merit in the submission of ld. Counsel for the assessee because, as rightly submitted by ld. CIT(DR), the TPO has not excluded loss making companies but only those companies which incurred persistent losses. It cannot be disputed that persistent loss making by ITA No. 5637/D/2011 93 a company in this sector is not in normal behavioral pattern of the industry as a whole. Therefore, it triggers the enquiry into the causes of losses. We are in agreement with ld. Counsel for the assessee that if a particular comparable is incurring persistent losses on account of certain extraordinary circumstances then only the same is to be excluded. However, the onus lies on assessee to demonstrate such extraordinary economic circumstances. We find that TPO has mentioned the distinction between the loss making company and a persistent losses/diminishing revenue making company. Ld. DRP has observed that TPO has examined the reasons for persistent losses. This filter was applied on the ground that such companies have some peculiar problems because of which the revenue was declining and not in line with the growth of software industry. Considering the statistical data noted earlier, it can safely be observed that declining turnover and persistent loss is not a normal phenomenon of this sector under the Indian economic conditions. Diminishing revenue/persistent loss are not in conformity with the normal operational results in this line of activity. Therefore the reasons for persistent losses incurred by a company needs to be identified.
50. Ld. Counsel has pointed out various aspects in regard to decisions relied upon by ld. CIT(DR) which are noted in his submissions earlier. In our opinion merely because one comparable has been accepted or rejected in a particular case cannot be a basis for accepting or rejecting the same in every transfer pricing analysis. Each case has to be considered on its own facts and ITA No. 5637/D/2011 94 only broad guidance can be taken from the decisions rendered in regard to transfer pricing issues.
50.1 Ld. Counsel for the assessee has referred to the decision of Spl. Bench in the case of Quark Systems, 32 TTJ 1 in support of its contention that just because a company is making loss it cannot be excluded. In this regard it would suffice to observe that TPO has not excluded the comparables merely on the ground that they were incurring losses but only when the comparable was incurring persistent loses and the revenue was diminishing due to some abnormal circumstances. We appreciate the argument of ld. Counsel for the assessee that the sweeping generalization that persistent losses show some abnormal circumstances is based on conjectures. However, when TPO has examined the comparables independently and has examined the reasons for same then it cannot be said that the exercise undertaken by the TPO was not in consonance with the general principles guiding the selection of comparables. We appreciate ld. Counsel's submissions that instan,ce of loss usually arises due to market forces/computation, emergence of new technologies or processes, increased costs, variation in demand and subject, and these are all normal economic factor which impact all industry player. However, this argument, when considered taking into account the holistic view of the IT Industry, cannot be accepted because all the factors enumerated by ld. Counsel, which results into loss, do occur in all comparables but still overall industry in this sector had shown considerable growth. We will consider each and every comparable separately and while undertaking that exercise take into ITA No. 5637/D/2011 95 consideration all the aspects emphasized by ld. Counsel for the assessee. However, in principle we are in agreement with TPO that given the trend of IT Industry growth persistent loss making companies cannot be taken as comparable because that in itself reflects existence of abnormal circumstances which. of course, needs to be identified. Therefore, the impugned comparable can be taken into consideration only if reasonably accurate adjustment can be made to eliminate the material effects of such differences but if that is not possible then in conformity with the requirements of Rule10B(3) of the Income- tax Rules, 1962, the said comparable is to be excluded.
51. In the result, this ground is dismissed.
52. Vide ground no. 4.5.4, the assessee has assailed the TPO's action in applying the filter of excluding the companies which have related party transactions of more than 25%. The TPO noticed that assessee did not mention anything regarding related party transaction filter. He, therefore, issued show cause notice stating therein that this filter is appropriate to eliminate the companies which have controlled transactions and, thereby, have its significant influence on the margin earned. The TPO, after dealing with the objections of the assessee and after taking into consideration the definition of the associated enterprises u/s 92A(2)(a), 40A(20)(b), OECD Guidelines and the mandate of Rule 10B(1)(e)(iii) that net profit margin is required to be adjusted to take into account differences which could materially affect the amount of net profit margin in the open market and also Rule 10B(3)(i) mandating such adjustment, concluded that related party filter of 25% is an adequate filter ITA No. 5637/D/2011 96 because on the one hand it will help in excluding the companies with significant controlled transactions and at the same time it also helps in obtaining an adequately large sample size.
53. Ld. DRP, after considering the assessee's submissions, upheld the TPO's action. It relied on the decision of Delhi ITAT in the case of Sony India Pvt. Ltd. As regards the contrary view taken by Bangalore Bench of ITAT in the case of Philips Software Centre Pvt. Ltd. vs. ACIT (2008) 26 SOT 226, Ld. DRP pointed out that Hon'ble Karnataka High Court had admitted the issue of effect of related party transaction in selection of comparable as substantial question of law for adjudication and had stayed the judgment of Bangalore Bench ITAT vide order dated 16/02/2009 in ITA No. 49/2009 reported in 2009-TIOL-123-HC- Kar.-IT.
54. Ld. Counsel for the assessee submitted that application of this filter depends on the facts and circumstances of each case and there cannot be any thumb rule for applying filter of 25% RPT. An objective criteria has to be adopted. Ld. Counsel submitted that the ideal situation would be where enough comparables are available by not applying this filter. However, if sufficient comparables are not available then gradually the limit has to be increased. Ld. Counsel submitted that there is conflict of judicial opinion on this issue and, therefore, no standard figure can be taken.
55. Ld. CIT(DR) referred to para 8.1page 36 of TPO's order and pointed out that assessee in principle had no objection for applying this filter. He submitted that threshold limit of 25% was quite reasonable, as applied by TPO ITA No. 5637/D/2011 97 because otherwise sufficient number of comparables would not be available. In this regard ld. CIT(DR) referred to para 28, 29 & para 40 of Actis, wherein this threshold has been accepted. He submitted that if more than 25% related party transactions are there then only it is uncontrolled. Ld.CIT(DR) further pointed out that in the case of Global Logic India Pvt. Ltd. for A.Y. 2006-07 vide order dated 31/12/2012, it has been clarified in para 5.17 as to what should be included for determining related party transaction. In this case, the capital was of 50 crores and out of the total sale of 45 crores, sale to related parties were only 25 crores and the balance 20 crore sale was to the third party. Therefore, this was excluded applying RPT filter.
55.1 Ld.CIT(DR) submitted that this filter has rightly been applied because related party transactions influence the price of transaction. He submitted that exclusion of companies with related party transaction up to 25% was quite reasonable for which guidance has been taken from the provisions of section 92A(2)(a) which provides a limit of 26% for treating an enterprise as associated enterprise. His submissions are reproduced hereunder:-
Exclusion of companies with related party transactions up to 25% of their sales; Counter:
This is the filter of Related Party Transactions up to 25% of Sales.
(Pl. See Pages 36 till 38, being para 8.1 of TPO) The following case laws support Revenue, wherein this limit has been approved.
i. M/s Actis Advisers (I) (P) Ltd. - 5227/Del/2011 (paras 28 and 29) ITA No. 5637/D/2011 98 ii. M/s Deloiette Hyderabad, ITA No. 1082/Hyd./2010, dtd.
22/07/2011 (para 35 of this order) iii. M/s ST Micro Electronics (I) (P) Ltd. (15 ITR (Trib.) 410 Del) -
paras 40 and 41 iv. M/s Global Logic (I) (P) Ltd. 2011-T11-35-ITAT-Delhi-TP. Dtd.
25/03/2011, paras 4 and 5, till para 5-17 (ITA Nos.
6082/Del/2010, A.Y. 05-06) v. M/s Hapag Loyd, ITA No. 8499/Mum./2010, dtd. 28/02/2013, para 6-2, wherein they have relied on the case of M/s Thysen Krupp, Mumbai, ITA No. 6460/Mum./2012.
55.2 We have considered the rival submissions and have perused the record of the case.
56. We are in agreement with TPO in principle that this filter is appropriate to eliminate the companies which have controlled transactions and thereby have a significant influence on the margins earned. The TPO in his order has observed that in principle the tax payer has no objection for applying this filter. However, its two main contentions are-one-availability of RPT information and second the threshold limit of 15% in place of 25%. At the same time we also find considerable force in the submission of ld. Counsel for the assessee that ideally if sufficient number of 100% uncontrolled comparables are found, then no comparable having related party transactions should be considered. We are in agreement with ld. Counsel that only when sufficient comparables are not found, the related party threshold should be relaxed and ITA No. 5637/D/2011 99 only gradually to the extent that sufficient comparables are found, the limit should be relaxed. Therefore, we accept the assesse's plea that no sacrosanct threshold limit should be fixed for this filter. Ld. DRP has also noted that neither there is any judicial consensus on the numerical limit nor the section so prescribes. However, there is consensus on the effect of RPT i.e. it should not materially affect the international transaction. Therefore, considering the submissions of both the sides, we are of the opinion that if by applying the threshold limit of 15% of related party transaction, sufficient comparables are available then there is no reason to further extend the limit to 25%. Therefore, we direct the TPO to take into consideration only those comparables where related party transactions are to the extent of 15% because it is not the case of revenue that by applying the threshold limit of 15%, it will not get sufficient number of comparables.
57. In the result, this ground is allowed.
58. Vide ground no. 4.5.5, the assessee has assailed the application of filter by TPO of adopting employee cost greater than 25% of their total revenues as a search criteria for short listing and evaluating comparables for software development services. The TPO noticed that the assessee is a software development services provider and incurs 64% of sales as salary expenditure.
He pointed out that in the case of a Software Development Company, employees are the main asset of the company and directly reflect the nature of business undertaken by the company. He noted that as per prowess data base, the average employee cost works out to about 35% of sales in the case ITA No. 5637/D/2011 100 of companies having turnover more than 1 crore for the F.Y. 2006-07. He pointed out that extremely low expenditure on salary/employee cost is a definite indication that the company is either into further outsourcing of the work or is a software product developer or a software trading company. He, therefore, applied filter of 25% of minimum salary expenditure to sales while searching for comparables. The TPO, after dealing with various objections of assessee, concluded that application of this filter was fully justified. He further pointed out that no comparable had been accepted/rejected merely on this count and this filter was applied just to consider functionality of such companies in detail. He pointed out that detailed analysis of companies with employee cost less than 25% was done. Ld. DRP confirmed the TPO's action, inter-alia, observing that since this is the main cost component in the sector, use of the filter cannot be considered as inappropriate. It further pointed out that, in any case, the TPO did not reject any company only on the basis of employee cost. Where a company had failed this filter, a notice u/s 133(6) had been sent to ascertain the actual functional profile of the company. Therefore, this filter had been used as a starting point to carry out a more thorough functional analysis.
59. Ld. Counsel for the assessee submitted that this is not a filter of comparability provided in Rule 10B(2). He submitted that the comparability analysis has to be necessarily based on an imaging of the function - asset - risk (FAR) profile of the tested party against the comparable company. He pointed out that even though two companies may be employing same level of personnel, yet the manner in which the remuneration to those personnel is paid ITA No. 5637/D/2011 101 and classified from an accounting perspective may have a significant bearing on their respective wages/sales ratio and, thus, reduce reliability of any analysis based on use of wages/sales ratio. He further pointed out level of wages depends upon company policy and market forces. It is a known fact that big MNCs, outsourcing their work in India, generally have better pay scales than certain Indian Companies performing similar or more complex activities. He referred to the decision of Hyderabad Bench in Hello Soft India Pvt. Ltd. vide ITA No. 645/Hyd./09 and pointed out that ITAT rejected this filter as the relevant data in this regard was not available and many companies include employee cost data under different heads. Ld. Counsel pointed out that TPO had obtained information u/s 133(6) for applying this filter. He submitted that data used should be available in public domain.
59.1 Ld.CIT(DR) submitted that in software companies major cost is salary cost. Software development involves using man power or brain power. Therefore, there has to be a cut off for finding out whether the company is in software development sector or only a trading company. Therefore, the threshold of 25% of employee cost being considered as minimum employee cost for selecting comparables is quite reasonable.
59.2 Ld. CIT(DR) relied on the order of TPO in this regard and submitted that his filter has been approved in following cases:
• M/s Bitharis Technologies (para 5.3) (ITA No. 4372/Del/09) • M/s Asia India Pvt. Ltd. (ITA No. 5350/Del/2010) (para 19) • Navisite (paras 20 to 22) ITA No. 5637/D/2011 102 59.3 He submitted that in the case of M/s Hello Soft India Pvt. Ltd., relied by asessee, there was only cryptic reference, as opposed to detailed discussion in cases relied by revenue.
60. In the rejoinder, ld. Counsel submitted that in the case of Asia India Pvt. Ltd., considering the fact that employee cost to sales was 46%, the range of employee cost to sales was fixed at 30% to 60%. He, therefore, submitted that in the case of assessee since the employee cost to sales ratio is 64%, the threshold of 25% would be inappropriate. Ld. Counsel, therefore, submitted that if, at all this filter is to be applied, then, the appropriate range would be 50% to 80%.
60.1 We have considered the rival submissions and have perused the record of the case.
61. As far as ld. Counsel's objections of data being not available in public domain is concerned, for which TPO resorted to obtain information u/s 133(6), we find that this objection of ld. Counsel is not sustainable particularly because ground no. 4.4 dealing with this issue has not been pressed by him. Even otherwise, we find that TPO has been vested with specific powers u/s 92CA(7) to obtain information u/s 133(6) if he so considers for the purposes of determining the arm's length price. The whole exercise of transfer pricing analysis centrifuge towards determining the arm's length price of the international transaction and for that purpose TPO has been vested with wide powers so as to arrive at arm's length price. He has to take into consideration various factors affecting the price of international transaction and collect the ITA No. 5637/D/2011 103 quantitative information in that regard either from data available in various data bases e.g. prowess and capitaline or resort to obtaining independent information u/s 133(6). The powers contained u/s 92CA(7) cannot be curtailed or abridged by putting unrealistic impediments. These powers have been given for collecting the necessary information. However, before relying on this information, assessee has to be confronted with the information. The next objection of ld. Counsel for the assessee is that the comparability analysis has to be necessarily based on a mapping of FAR profile of the tested party against the comparable company. There cannot be any quarrel with this proposition. The TPO has not given a go bye to FAR analysis while applying this filter. This is a functional filter and if a company fails this filter, it indicates that either it is outsourcing major part of the work; a predominantly on-site company (as it does not show the payments made to on-site consultant under the employee cost); a software product company or trading company or a company with peculiar economic circumstances. The submissions of ld. Counsel, therefore, cannot be accepted. This filter has been applied on the ground that companies which are engaged in software development require a minimum level of expenditure on personnel expenses. In our opinion, in order to consider the functional similarity of two comparables, it is necessary that such quantitative filters are applied to reach a reasonable conclusion regarding functional similarity. However, we find considerable force in the submission of ld. Counsel for the assessee that while fixing the range for applying this filter, regard should first be to the employee cost to sales ratio of tested party viz. assessee. He has rightly pointed out that ITA No. 5637/D/2011 104 in Asia India Pvt. Limited (supra) since the employee cost to sales was 46%, therefore, the range of employee cost to sales was fixed at 30% to 60%. In the present case since the employee cost to sales ratio is 64%, we accept the assessee's contention that the filter has to be applied by applying the range of employee cost to sales of 50% to 80%. We direct accordingly.
62. In the result, this ground is partly allowed.
63. Vide ground no. 4.5.6 the assessee has assailed the TPO's action of applying on-site revenue filter. By applying this filter, the company's whose on- site revenues exceeded the 75% of total export revenues, were rejected as comparable.
64. Ld. TPO summarized the assessee's objections to this filter as under:
(a) "The Indian software sector provides both on-site and offshore services.
(b) The Indian vendors have succeeded in raising the share of offshore revenue from 44% in 2000-01 to 64% in 2003-04, 71 % in 2004-05 and to 74% in 2005-06. Though the data is not available for the FY 2006-07, the annual report of big software companies shows that this ratio is increased further during the FY 2006-07. Most of the uncontrolled enterprises follows hybrid model with revenue mix both from onsite and offshore. The taxpayer is mainly offshore service provider and it is difficult to get independent companies which generate revenues only form offshore software development service providers.
(c) The pricing is different in onsite when compared to offshore operations. The reasons for the same lie in the fact that while in the case of OFFSHORE projects most of the costs are incurred in India; an ONSITE project has to be carried out abroad significantly increasing the employee cost and other costs. The Indian companies have therefore been slowly moving towards the OFFSHORE work more and more.
(d) The companies which are predominantly onsite companies do not have significant ITA No. 5637/D/2011 105 assets as most of the work is carried on the site of customer outside India.
(e) The companies who generate more than 75% of the export revenues from onsite operations outside India are effectively companies working outside India having their own geographical markets, cost of labour etc and also return in commensurate with the economic conditions in those countries.
(f) Thus assets and risk profile, pricing as well as prevailing market conditions are different in predominantly onsite companies from predominantly offshore companies like the taxpayer."
64.1 The TPO, however, did not accept the assessee's objections and pointed out that the business dynamics of on-site and offshore varies a lot. He summarized his findings based on "Industry overview of software services sector," as under:
• The Indian Software Sector provides both on-site and offshore services; • The Indian vendors have succeeded in raising the share of offshore revenue from 44% in 2000-01 to 64% in 2003-04 and to 71% in 2004-05; • There is a substantial rate difference between the on-site and offshore projects/contracts;
64.2 He pointed out that as per the industry reports (source-annual report of emphasis BFL F.Y. 2004-05), in the year 2004-05 average rate per man hour in the case of Offshore projects was US-18 dollars, whereas the same was considerably higher in the case of on-site project at about 66US dollars per man hour. He, therefore, pointed out that the profit margin also accordingly vary significantly; the offshore projects have much higher margins. The reasons for the same lie in the fact that while in the case of offshore projects most of the ITA No. 5637/D/2011 106 costs are incurred in India, an on-site project has to be carried out abroad significantly increasing the employee cost and other cost. The Indian companies have therefore, been slowly moving towards the offshore work more and more. He pointed out that the higher cost of on-site workers holds operating margins in the low of 20%. The TPO referred to various sources to buttresses his contention. He, therefore, concluded that the tax payer, whose business is entirely offshore, cannot be compared with a company which has substantial revenues generated from its on-site operations. As regards the assessee's objections that nature of activity regarding software development services do not change between on-site and offshore software development services, the TPO observed that merely because a company is into software development does not automatically become comparable because the economic circumstances should also be comparable between the tax payer and the comparable. The TPO further pointed out that there is no dispute that Indian Software Companies do follow hybrid model. He pointed out that as per NASSCOM, during the financial year 2005-06, 74% of the revenues was from offshore software development. That is the main reason why all the independent comparable companies do have some part of their revenues generated from their on-site operations. He further pointed out that from the analysis of various annual reports of software development companies, it is evident that the profitability of the company gets affected adversely if the on-site revenue mix go beyond 75% of the export revenues. Therefore, the application of 75% on-site revenue filter was justified.ITA No. 5637/D/2011 107
64.3 The TPO further pointed out that assessee limited its analysis only to functions but not to the assets, risks as well as prevailing market conditions in which both the buyer and seller of service were located. The TPO referred to Rule 10B(2) and pointed out that apart from the functions, the following characteristics are also important in comparability analysis:
• Assets employed and risks assumed; • Conditions prevailing in the market in which both the buyer and seller of
services are located including the geographical location, size of the market, cost of labour and capital in the market, overall economic development and level of competition.
65. In sum and substance, the TPO's conclusions were as under:- A company which operates predominantly on on-site work differs from tax payer as under:
o The market conditions are different for on-site then offshore work;
o The pricing structure is different on the inside work;
o The assets are negligible in the operating on-site companies as they utilise the assets of their customer;
o The margins for on-site are lower when compared to offshore work;
o The labour markets are different for offshore and on-site work as the people who are working from on-site get competitive salaries of the countries where the work is actually performed;
o Cost arbitrage is not available for the on site work;ITA No. 5637/D/2011 108
o The companies whose revenues are generated mainly from on-site work almost mimic a company which is resident in that company. He further pointed out that the companies who were also operating through their branches for their on-site work were also subjected to this filter.
66. As regards the assessee's argument that offshore and on-site revenues may individually yield diferring profit margins and , therefore, needs to be considered on a holistic basis, the TPO pointed out that comparables margins were considered at the enterprise/segmental level. The offshore margins neither were calculated for the comparables nor obtained from the companies u/s 133(6).
66.1 In view of above findings, the TPO applied the on-site revenues filter wherein the companies generating more than 75% of their export revenues from on-site operations were rejected as comparables.
67. Ld. DRP concurred with the findings of TPO.
68. Ld. Counsel has advanced following submissions in this regard:
• If this filter is to be applied then whole process of determination of arm's length price will get delayed till TPO examines the issue because the annual report does not contain information in regard to onsite and offshore revenue separately. This information has been obtained by TPO u/s 133(6). • Such a filter is contrary to the statutory scheme provided in the Act & Rules;
• A company is judged to be a comparable or otherwise based on parameters relating to functions risks and assets;ITA No. 5637/D/2011 109
• Software development activity comprises both offshore and on-site development. These services are provided in bundled manner. So even if a profit margin may be low in on-site work, it should not be viewed in isolation but in conjunction of offshore work because both the activities are performed as a compliment to each other and not as independent activities. Also lower margins can be compensated by higher volumes;
• Profitability cannot be considered as a comparability factor under Rule 10B(2). There is no empirical analysis performed by TPO that the operating model of cost, revenue and consequent margin are significantly different for a set of predominantly on-site companies vs. predominantly offshore companies; • TPO has not provided any empirical evidence to show that function, asset and risk profile of a predominantly on-site software service company is different from an offshore software service provider. As regards Revenues contentions that the consideration of market cannot be ignored in view of Rule 10B(2), ld. Counsel submitted that market is a place where competition happens not where the work is performed. He submitted that as per revenue, assets and market are different and asset is not important. He pointed out that assessee had applied asset filter which TPO rejected. ;
• The filter is self contradictory because the threshold of 75% is quite high. If on-site revenue is a material factor then why TPO should allow such a high threshold.
69. Ld. Counsel relied on the decision of Hello Soft India Pvt. Ltd. (ITA No. 645/Hyd./2009), wherein Tribunal rejected this filter observing that relevant ITA No. 5637/D/2011 110 data in this respect is not available in the data base. All the on-site information had been obtained by the TPO u/s 133(6) which is un-audited.
70. Ld. CIT(DR) submitted that this filter has been approved in the case of Trilogy E-business Software India Pvt. Ltd., ITA No. 1054/Bang./2011 dated 23/11/2012 A.Y. 2007-08 (paras 52 till 67 of the order). As regards the decision relied upon by ld. Counsel for the assessee, ld. CIT(DR) pointed out that this decision has just made a passing and cryptic reference, as opposed to detailed discussion in M/s Trilogy E-Business India Software Ltd. (supra). He further pointed out that assessee had relied upon this decision for different proposition. 70.1 Ld. DR explained that on-site and off site distinction has to be taken into consideration in order to select comparables. In this regard ld. DR explained that medical company may be earning export revenues from X-ray digitally transferred and also from specialist going abroad. He submitted that in case of first viz. x-ray digitally transferred, the same is offshore revenue though export earning but the other one viz. specialist going abroad is on-site revenue because the services were rendered on-site. He submitted that the revenue earned from both these activities entail altogether different cost structure and cannot be compared with each other. He submitted that margins of profit from on-site revenue is much less than the profit margins earned from off site revenues. Ld. DR further submitted that if on-site revenues earned from export were more than 75% then the said company had to be excluded since assessee was mainly earning offshore revenues from export. He submitted that this is in line with Rule 10B(2) particularly clauses (b) & (d) which require that ITA No. 5637/D/2011 111 comparability of an international transaction with an uncontrolled transaction is to be judged with reference, inter-alia, to the functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties and also the conditions prevailing in the market in which the respective parties to the transaction operate, including the geographical location and size of the market, the laws and government orders in force, cost of labour and capital in the markets, overall economic development and level of competition, etc. Ld. DR further pointed out that the AE is located in USA where minimum wages payable to an employee are much more than Indian wages. Ld. DR referred to the decision in the case of Trilogy and pointed out that para 67 of the said decision covers this issue. Ld. CIT(DR) submitted that assets employed will be lesser in case of on-site operator and will affect FAR analysis. He submitted that companies having on-site revenue of more than 75% are not selected on basis of profit margins. Ld. DR pointed out that offshore companies are thriving because of cost advantage and economic conditions of market. He submitted that as per Rule 10B(2)(d), which specifically requires consideration of conditions prevailing in the markets in which the respective parties performs, on account of geographical differences, such companies are not comparable. Ld. DR further submitted that under TNMM Method, there has to be brought comparability only within the framework of our legislation.
70.2 We have considered the rival submission and have perused the record of the case.ITA No. 5637/D/2011 112
71. From the submissions advanced by ld. Counsel for the assessee, it is clear that it is not disputed that the profit margin in case of on-site work is normally low as compared to offshore work. The TPO has clearly demonstrated with facts and figures that there is considerable difference between the average rate per hour in the case of offshore projects vis-a-vis on-site projects. The reasons given by TPO are well founded. As the on-site project is altogether a different segment of the business and, therefore, the factors which influence the profitability of that segment have to be considered before considering the same for comparability study. In on-site projects the assessee utilizes the assets of the client whereas in offshore project the assessee utilizes its own asseets.
This itself brings considerable difference in the comparability of the two segments by affecting the profitability. The salary structure in case of on-site project is governed by the economic conditions prevailing in the resident country where work is actually performed, whereas in offshore projects, Indian conditions govern the salary structure which is much lower as compared to the country where associated enterprise is located. We, therefore, do not find any reason for not accepting the TPO's contention in this regard.
72. Ld. Counsel has submitted that the threshold of 75% is quite high. In our opinion, this argument of ld. Counsel cannot be accepted because, admittedly, the profitability in case of on-site project is much less than offshore projects. Therefore, TPO was quite fair when it applied the on-site revenue's filter considering the companies generating more than 75% of their export revenues from on-site operations. This resulted into accepting those ITA No. 5637/D/2011 113 comparables where companies were generating less than 75% of their export revenues from on-site operations. This resulted in excluding only those comparables which were predominantly earning from on-site operations. This took care of the assessee's submissions also that Indian Software Companies follow hybrid model with a mix of on-site and offshore operations. 72.1 In view of above discussion, the ground raised by assessee stands rejected.
73. Brief facts apropos ground no. 4.5.9 are that TPO noticed that assessee had excluded the companies which incur expenses on R&D more than 3% of revenues. The assessee justified its search process on following grounds:
1. It eliminates companies owning intellectual property rights;
2. It eliminates companies that entail different level of risks and are functionally different. Incurring R&D expenditure at a material level makes the company a significant risk bearing entity because R&D activity is not a predictable process. It can succeed or fail depending upon unknown factors. If it fails, the assessee will incur a dent in its profit and on the contrary if it succeeds then it stands to gain significantly by way of increased revenues.
Other companies that do not incur R&D expenditure at a substantial level do not bare this risk and do not stand to gain or loose in this regard. Further a software development company cannot be compared with a simple software service provider in the case of Captive Service Provider of a Multi National like assessee, the overseas parent, company the entrepreneur organization drive ITA No. 5637/D/2011 114 the R&D. Accordingly, it bares the risks related to the success or failure of the R&D and the possibility of the invention or the discovery being created through such R&D. The assessee does not incur any amount on R&D.
3. The assessee itself has taken the comparables incurring upto 0 to 3% of total revenues on R&D but excluded various companies with very high expenses on R&D expenses such as Electronics Software Systems, Wipro Ltd., Tata Elxsi Ltd., Sasken Communication Technologies Ltd., Sab Lab Ltd., all these companies are Software Product Development Companies and have their own proprietary products and patents. It is not a coincidence that companies that incur substantial R&D expenditure are product companies and own intellectual property rights.
74. The TPO did not accept the assessee's contention observing that for creating intellectual property rights, R&D is required but the converse is not true i.e. each company is spending on R&D automatically is not towards creating an IPR. The R&D activity in a software development company is to improve the processes in delivering the software development services and not in creating intangible. TPO further pointed out that even bigger companies like Infosys spend on R&D but not in creating intangible (other than relating to products). TPO has reproduced at page 25 extracts from an annual report of Infosys for the F.Y. 2006-07, wherein it has been, inter-alia, observed as under:
"R&D of new services, designs, frameworks, processes and methodology continue to be an importance of us. This allows us to enhance quality, productivity and customer satisfaction through continuous innovation." ITA No. 5637/D/2011 115
74.1 TPO further pointed out that Infosys had spent an amount of Rs. 167 crores as R&D out of which Rs. 48 crores was spent on its banking software product, Finacle. The remaining amount of Rs. 119 crores was spent on other activities. Therefore, the main intention of R&D Infosys was either to develop its software product, Finacle or to enhance quality productivity and customer satisfaction through continuous innovation of designs framework processes and methodology of the services delivered by it. Therefore, it can be inferred that R&D Software Industry is always not to create only IPR's but also to create tools/processes to improve the quality of services being rendered. As regards assessee's contention that it being a captive service provider does not invest in R&D but its parent company invest in R&D, TPO observed that risk of R&D is borne by a parent company. TPO further pointed out that the comparable companies are also mainly involved in the development of software similar to the tax payer. He pointed out that this filter is not relevant as the expenditure on R&D is also towards improving the processes as well. With reference to the reliance placed on OECD Guidelines regarding high risk of failure of investment in R&D and consequently high cost pressure of successful product coming out the R&D activity, TPO pointed out that there is no dispute that companies investing in huge R&D specifically in pharmaceutical and other R&D intensive industry like software products, the risk of failure is very high. Therefore, the intention of the assessee in applying R&D filter appeared to reject companies with producst based on the R&D expenditure. However, in a service industry like software industry, R&D expenses do not indicate whether a company is a ITA No. 5637/D/2011 116 software product company or not. He pointed out that by application of this filter, some companies were rejected as comparables even though they are not Software Products or they do not have significant revenues (more than 25%) from software products e.g. Flextronics Software Systems Ltd. was rejected by the company by applying this filter. But the companies product and services segment had product revenues only to the extent of 10.87% of the segmental revenues. Therefore, the filter application did not yield intended results. Similarly, the filter did not reject all the Companies with products though the assessee is mainly software development company. Therefore, the comparables had to be pre-dominantly engaged in software development services. However, by applying this filter, the assessee could not eliminate software product companies. Further, some of such companies were rejected by the assessee company being product companies though they qualified the R&D filter as under:
1. Aftek Ltd.
2. Essel Software & Services Ltd.
3. Iflex Solutions Ltd.
4. Intense Technologies Ltd.
5. Maars Software International Ltd.
6. Mirco Technologies (India) Ltd.
7. Teledata Informatics Ltd.
8. Transworld Infotech Ltd.
9. Tutis Technologies Ltd.
10. Vakrangee Softwares Ltd.
11. Zenith Infotech Ltd.
12. Take Solutions Ltd.ITA No. 5637/D/2011 117
13. ABM Knowledgeware Ltd.
14. Asian Cerc Information Technologies Ltd.
15. Shyam Telecom Ltd.
16. KALS Information Systems Ltd.
74.2 Thus, the aforementioned companies though passed the R&D filter applied by assessee but had to be rejected by assessee on the ground that they were product intensive companies. Therefore, it is evident that the expenditure debited in the profit and loss account under the head "R&D" is not conclusive proof of the company being a product company particularly in the case of Software Service Provider.
75. In contrast, ld. TPO pointed out that he had applied a filter, wherein all those companies whose revenues from software development services was less than 75% of the overall revenues/segmental revenues were rejected. This filter eliminates companies which were software product company as well. Ld. TPO further demonstrated that R&D filter applied by the assessee had on the one hand failed to eliminate the product companies and on the other hand resulted in elimination of following non-product companies which were actually companies engaged in software development services:-
S.No. Name of the Remarks of the TPO
company
1. Quintegra The company is into
Solutions Ltd. software development
Services and it does not
have any revenues
From sale of software
products.
2. Sasken The company has
Communications software services
Technologies segment.
Ltd. This segment does not
contain any revenue by
Way of sale of
ITA No. 5637/D/2011 118
products. Sasken
Communication
Technologies Ltd.
clearly stated in its
reply
That it has not incurred
any R&D expenses
In the software
development services
segment.
Though overall, the
company spent more
than
3% of the revenues on
research and develop-
ment, these expenses
are spent in the
software products
segment vindicating the
position of the TPO
that software product
companies incur
substantial R&D
expenses
but substantial R&D
expenses may not
indicate that a
company is a software
product company or
generating intangibles.
3. Tata Elxsi Ltd. The company has
software development
and
Services segment. This
segment does not
Contain any revenue by
way of sale of
Products.
4. Flextronics The company has
Software Systems software products and
Ltd. Services segment. In
this segment, more than
75% of the revenues
are generated from
Software development
services.
75.1 He, therefore, pointed out that the filter is inappropriate.
76. As regards, assessee's argument that R&D filter was applied not just to filter out product companies as mentioned in the show cause notice but to filter out comparable companies with technology intangible, intellectual property etc., ld. TPO pointed out that assessee did not show any single instance where ITA No. 5637/D/2011 119 the application of this filter eliminated companies with technology intangibles, intellectual property etc., even though such companies were not developing software products. Ld. TPO further pointed out that assessee had not explained any rationale for putting the limit of 3%.
77. Accordingly, ld. TPO concluded that there is no reason to exclude comparable companies engaged in R&D if they are software service providers.
He observed that the criteria may be a trigger to examine further whether the company has any sales by way of products or created any intangible which was exploited commercially for sale. But it cannot be applied as a filter because this filter also eliminates software development companies. Ld. TPO demonstrated that R&D expenses of the company and the margin earned by the comparable had no correlation by considering following comparable selected by him:
S.N Company Sales OP to % of
o. Name (Rs. Total R&D
Cr.) Cost% Over
sales
1. Accel 9.68 20.90 0.00%
Transmati %
c Ltd.
(Seg.)
2. Avani 3.55 50.29 0.00%
Cimconn %
Technolog
ies Ltd.
3. Celestial 14.13 58.35 17.83
Labs Ltd. % %
4. Datamatic 54.51 1.38% 0.00%
s Ltd.
5. E-Zest 6.26 35.63 0.00%
Solutions %
Ltd.
6. Flextronic 848.66 25.31 0.46%
s Software %
Systems
Ltd. (Seg.)
7. Geometric 158.38 10.71 0.00%
Ltd. (Seg.) % %
8. Helios & 178.63 35.63 0.00%
Matheson %
ITA No. 5637/D/2011 120
Informati
on
Technolog
y Ltd.
9. IGate 747.27 7.49% 0.00%
Global
Solutions
Ltd.
10. Infosys 131.49 40.30 1.27%
Technolog %
ies Ltd.
11. Ishir 7.42 30.12 0.00%
Infotech %
Ltd.
12. KALS 2.00 30.55 0.00%
Informati %
on
Systems
Ltd. (Seg.)
13. LGS 45.39 15.75 0.00%
Global %
Ltd.
(Lanco
Global
Solutions
Ltd.)
14. Lucid 1.70 19.37 0.00%
Software %
Ltd.
15. Mediasoft 1.85 3.66% 0.00%
Solutions
Ltd.
16. Megasoft 139.33 60.23 0.00%
Ltd. %
17. Mindtree 590.35 16.90 0.00%
Ltd. %
18. Persistent 293.75 24.18 0.92%
Systems %
Ltd.
19. Quintegra 62.72 12.56 0.62%
Solutions %
Ltd.
20. R S 101.04 13.47 0.00%
Software %
(India)
Ltd.
21. R Systems 112.01 15.07 0.56%
Internatio %
nal Ltd.
(Seg.)
22. Sasken 343.57 22.16 0.00%
Communi %
cation
Technolog
ies Ltd.
(Seg.)
23. SIP 3.80 13.90 0.00%
ITA No. 5637/D/2011 121
Technolog %
ies &
Exports
Ltd.
24. Tata Elxsi 262.58 26.51 4.15%
Ltd. (Seg.) %
25. Thirdware 36.08 25.12 0.00%
Solutions %
Ltd.
26. Wipro 9616.0 33.48 8.50%
Ltd. (Seg.) 9 %
77.1 He pointed out that three companies viz. Tata Elxsi, Celestial Labs &
Wipro Ltd. had a ratio of marketing expenses to sales of more than 3% but still they remain software development companies.
78. Ld. DRP accepted the ld. TPO's contention that rejection of this filter had no material impact in the case of assessee. Ld. DRP, inter-alia, pointed out that spending on R&D does not necessarily result in creation of IPR. The R&D activity in a software company may be with respect to improving process of delivery of services (software development services) rather than creation of intangible. Ld. DRP relied on analysis of statistical data of various companies as demonstrated by ld. TPO, noted above.
79. Ld. Counsel for the assessee relied on the written submissions filed by it as noted earlier.
80. Ld.CIT(DR) submitted that there is no basis for adopting 3% limit of R&D expenses to sales. He pointed out that assessee has not demonstrated as to how profitability got affected by incurring expenditure more than 3% on R&D to sales. Ld. DR further submitted that since expenditure had already been debited to the profit and loss account, therefore, the profits were lower and hence had no impact on operating profitability of comparable. He ITA No. 5637/D/2011 122 submitted that the assessee had not demonstrated that R&D activity changes the functionality of a software development.
The submissions of ld. CIT(DR) are reproduced as under:-
Rejecting assessee's filter of accepting companies having research and development costs to sales less 3%.
Counter:
The TPO has covered this in his order on page 29 till 32.
How does R&D expenditure influence profits or FAR analysis, needs to be established. The cut-off figure of 3% is adhoc, random and without any basis.
Revenue finds Support from the case of M/s Deloitte Consulting (I) (P) Ltd.
1082/1084/Hyd./2010, para 36 thereof.
Further, the need for correlating expenditure to FAR and profits has been demonstrated in the case of M/s Actis Advisers P. Ltd. ITA No. 5277/Del/2011, para 19, 20 and 26 thereof.
80.1 Ld. DR referred to the order of TPO and pointed out that this can only be a criteria to trigger the further examination as to whether the company has any sales by way of products or created any intangible which was exploited commercially for sales. But it cannot be applied as a filter because this filter also eliminates software development companies. Ld. DR referred to the transfer pricing study contained at Paper Book Vol. III and referred to page no.
1020 of the same to demonstrate that in the search process companies with the ratio of the sum of advertising marketing and distribution expenses to sales less than or equal to 3% were 340. However, when qualitative filters were applied ITA No. 5637/D/2011 123 by considering companies engaged in software development activities broadly similar to those carried out by assessee then only 11 comparables were left. Therefore, by applying this filter sufficient number of comparables which were functionally similar got excluded. Ld. DR further submitted that para 19 to para 24 of Actis covers this issue. Ld. CIT(DR) pointed out that how does R&D expenditure influences profits and FAR analysis, needs to be established. He submitted that research activity does not change the functional profile of an entity and thus, does not make the same as not comparable to the assessee. Research activity has no direct correlation to profits or margin.
81. In the rejoinder, ld. Counsel for the assessee submitted that the decision of Deloite Consulting India P. Ltd. (supra) is of no assistance to revenue as the issue discussed in para 36 is not in relation to the filter in question i.e. R&D expenditure being 3% or more of the sales. In this case, the suitability of one particular comparable was discussed based on peculiar facts of the comparable. He submitted that it is pertinent to note that Deloite Consulting India P. Ltd. and the comparable in question were not software development companies, but companies providing information technology enabled services which are in the nature of business process outsourcing. In this case, the R&D Investment does not matter much as the services are in the nature of back office support. Ld. Counsel further pointed out that as per Rule 10B(2) functional comparability is the most important determining factor in selecting comparables. However, research is an additional function which the assessee does not undertake and hence incurred zero expenditure on any ITA No. 5637/D/2011 124 research activity. Therefore, the assessee had excluded the companies engaged in any kind of research activity. As regards ld. CIT(DR's) submission that a correlation has to be established between research and development activity and profitability to determine whether this filter should at all be applied or not, ld. counsel submitted that R&D expenditure is an investment i.e. made with the hope of reaping benefit there from. If substantial expenditure is incurred on R&D the company exposes itself to additional risk not borne by companies that do not incur any R&D expenditure. He pointed out that Rule 10(B)(3) does not require the assessee to demonstrate a positive correlation between any difference and profitability. What needs to be seen is whether on the facts & circumstances if any differences are likely to impact the profit margin in a material manner, such a difference should be accounted for by way of an adjustment. In the event of such an adjustment not being possible, the comparable has to be excluded. Ld. Counsel further pointed out that the fact that Flextronics, Infosys & Suskins Technologies have undertaken significant research activity and as a result developed significant intellectual property and have also increased R&D expenditure proves the assessee's contention that there is a positive correlation between intangibles and R&D expenditure. Hence, such companies cannot be considered to be comparable to the assessee. As regards the threshold limit of 3% applied by assesse in regard to R&D expenditure to sales, ld. Counsel pointed out that what needs to be considered is whether such principle passes the test of materiality or not. He ITA No. 5637/D/2011 125 submitted that 3% of sales is a material amount which has the possibility of reducing the profits of a company materially.
81.1 We have considered the submissions of both the parties and have perused the record of the case. We are in agreement with ld. TPO's observations that for creating intellectual property rights, R&D is required but the converse is not true i.e. each company spending on R&D automatically is not towards creating an IPR. We are also in agreement with the observation of ld. TPO that R&D activity in a software development company is to improve the processes in delivering the software development services and not for creating an intanglible. But at the same time the submissions of ld. Counsel for the assessee that profitability of companies having intangibles is more cannot be lost sight off. If a company is having brand then it is definitely in a better position to command higher profits. Ld. Counsel in his submissions has pointed out that companies having patent had incurred substantial sums on R&D to develop its own products. Thus, both sides have their logical view point. Under such circumstances, the balance has to be drawn keeping in view the primary object of transfer pricing study. The object of selection of comparables is to find out companies which are performing similar functions as assessee with almost similar asset base and similar risks. These comparables are to be considered for finding out the arm's length price. If by applying a particular filter many, otherwise comparables, gets excluded then such a filter should be applied after making necessary adjustments for material factors. Thus, if a comparable has developed its own intellectual property right resulting into development of a ITA No. 5637/D/2011 126 patented product by incurring huge expenditure on R&D then even if it is performing software development functions, it has to be excluded. However, if a company is incurring huge expenditure on R&D only for improving the processes in delivering the software development services then the said comparable cannot be rejected merely because it is incurring R&D expenditure more than 3% of its total sales revenue because sufficient number of comparables are to be found for determining ALP. An objective decision has to be taken in each case. Ld. TPO has clearly demonstrated that by applying this filter even functionally similar companies gets excluded. This will result in limiting the number of comparables to a very small number. Thus, this will entirely frustrate the object of determination of the arm's length price. The contention of assessee that companies incurring expenditure greater than 3% on R&D were necessarily creating IP products is devoid of any merit. Therefore, this filter is to applied subject to proper analysis as observed earlier. In the result this ground is partly allowed in terms of aforementioned observations.
82. Vide ground no. 4.5.10 the assessee has challenged the rejection of its filter of accepting only those companies having ratio of advertising marketing and distribution expenses to sales less than 3% as comparables. Ld. TPO did not accept this filter for the same logic as for R&D expenses to sales. Ld. TPO observed that every independent enterprise has to incur marketing expenditure. In a service industry like software service, the assessee did not provide the basis on which such expenses resulted in any intangible unlike in ITA No. 5637/D/2011 127 manufacturing industry where substantial marketing expenditure creates an intangible. He, therefore, observed that this filter is not relevant in service industry like software development services. Accordingly, Ld.TPO show caused the assessee. In its reply the assessee, inter-alia, pointed out that marketing and advertising activities carried out by the entrepreneurial companies result in creation of marketing intangibles and thereby demand a return of such investment made in creation of such intangible. The assessee pointed out that Infosys Technologies Ltd., Wipro Ltd., Tata Elecsis Ltd., Flextronics have created a brand name for itself in the market and have made significant investment in creating such intangibles. The assessee further pointed out that along with application of this quantitative filter, qualitative analysis was also carried out for determining whether any marketing intangible existed or not. Ld. TPO, however, did not accept the assesee's contention, inter-alia, observing that assessee did not give the basis on which it concluded that Infosys Technology Ltd. etc., noted earlier, had created marketing intangible. He observed that in the case of manufacturing or distribution companies, expenses over a period of time may create marketing intangible. However, the same may not be true for service industry like software development services. Ld.TPO further demonstrated that it is not always true that marketing expenses result in better profitability. He pointed out that in the case of Infosys 95% of its revenue for F.Y. 2006-07 was derived from repeat businesses which implies that marketing expenditure had little impact on the profitability of assessee company. Ld. TPO has given the operating profit to ITA No. 5637/D/2011 128 sales ratio of various companies along with the marketing expenditure incurred by the said companies to demonstrate that expenditure on marketing has no correlation to the margin earned. Even in case of companies that have a marketing expense more than 3% of sales they are also software development companies.
83. Ld. DRP confirmed the TPO's action, inter-alia, observing that marketing expenditure in the case of service industry may lead to increased revenue but it has not been demonstrated with figures that such expenditure in the case of software service firms has lead to increased profitability. Ld. DRP also referred to the decision of ITAT Hyderabad in M/s Deloite Consulting India Pvt. Ltd. in ITA No. 1082 & 1084/2010.
84. Ld. Counsel for the assessee submitted that assessee does not take any marketing or advertising activity as the associated enterprise are contractually obliged to obtain the service from the assessee. Therefore, entrepreneurial companies, selected as comparable companies, carrying out marketing and advertising activity to create demand for their services and thereby to increase the share in the market cannot be taken as comparables. He submitted that return of such companies would include an embedded return towards marketing activities/efforts and related investment and risk. Hence, as in case of the R&D/sales filter, this filter also helps in the selection of the right set of companies by eliminating companies that may possibly own marketing intangibles. Ld. Counsel submitted that non-intangible companies cannot be compared with the companies having tangibles. Ld. Counsel further pointed out ITA No. 5637/D/2011 129 that it is an economic concept and for this no evidence is required to demonstrate its application and consequence.
Ld. CIT(DR) submitted as under:-
Rejecting assessee's filter of accepting companies having advertising, marketing and distribution costs to sales less than 3%.
Counter:
The need to correlate the expenditure on Advertising, Marketing and Distribution costs with profits or with FAR analysis needs to be demonstrated with empirical evidence. The assessee has failed to do so. The figure of 3% is adhoc, random, arbitrary and is designed/taken by the assessee to arrive at a prefixed conclusion.
Revenue finds support from the cases of i. M/s Actis Advisers P. Ltd. ITA No. 5277/Del/2011, para 19, 20and 26 thereof. (Directly on this issue).
ii. M/s Deloiette Consulting India (P) Ltd. ITA No. 1082/1084/Hyd./2010, paras 36 & 40.
84.1 We have considered the rival submissions and have perused the record of the case. Admittedly the reasons for rejection of this filter by Ld. TPO were similar to that for rejection of R&D filter applied by assessee. Ld. Counsel's submissions with respect of market intangibles in the form of brand being created by incurring heavy expenditure on advertising and marketing are well founded. If a comparable is having brand then its profitability is definitely better. We are in agreement with ld. Counsel for the assessee that for economic ITA No. 5637/D/2011 130 concepts evidence is not required but if the very objective of TP Study viz.
finding out suitable number of comparable fails then the proposed filter can be applied subject to necessary adjustment. In such circumstances a holistic view has to be taken. It is true that by incurring heavy expenditure on advertisement marketing and distribution the companies carrying on manufacturing activities do create marketing intangibles and in these cases a broad correlation between two viz. marketing intangible and sales would be reflected. However, as pointed out by ld. TPO, in case of Infosys though heavy expenditure was incurred on advertisement, marketing, etc. but 95% were the repeat customer. But, this factor on stand alone basis cannot be a deciding factor. We agree with Ld. CIT(DR) that assessee need to correlate the expenditure on advertising, marketing and distribution costs with profits or with FAR analysis with empirical evidence. Therefore, both, the outright rejection as well as acceptance of this filter as such, cannot be accepted. Therefore, for the reasons given in regard to ground no. 4.5.9 this ground is partly allowed.
85. Vide ground nos. 4.6 to 4.9, the assessee has challenged selection of various comparables by Ld. TPO on various grounds which we shall now discuss each comparable wise. However, before that we may reproduce the submissions of ld. CIT(DR) Ground No. 4.6 and 4.9 Including certain companies that are not comparable to the assessee in terms of functions performed, assets employed and risk assumed; ITA No. 5637/D/2011 131 Excluding certain companies on arbitrary/frivolous grounds even though they are comparable to the assessee in terms of the functions performed, assets employed and risk assumed;
Counter:
It is not possible to find exact replicas of an entity. In a TNMM situation, broad comparability is required. The assessee too, has, in its TP Study Report chosen broadly comparable entities. Please see pages 1019 till 1022 of paper book (being pages 53 till 56 of TP Study Report).
Further, the final comparables chosen by the assessee in its TP Study Report are on Paper Book pages 1043 till 1045, being pages 77 till 79 of TP Study Report. An examination of entities chosen by the assessee revcals that the comparable entities are into varied businesses such as custom software development, productized solution, turnkey services business analysis services, project consulting, application product engineering services, etc. In the case of M/s Hapag Lloyd Services P. Ltd. ITA No. 8499/M/2010, dtd. 28/02/2013. It has been held that the mere fact that a comparable has been accepted in one case, does not mean that it should be acceptable in all other cases, para 4.3.
Further, there cannot be exact replicas of an entity. Only broad comparability is required. In fact, this is the reason that then benefit of +-5% safe Harbour limit has been provided. Also, in a situation of mean, differences get evened out. Support is found from the following case laws:ITA No. 5637/D/2011 132
i. M/s Symantec Software Solutions P. Ltd. ITA No. 7894/Mum./2010, para 16.
ii. M/s Actis Advisors P. Ltd. ITA No. 5277/Del/2011, para 35.
iii. M/s Deloitte Consulting Hyderabad. ITA No. 1082- 84/Hyd./2010, para 36 and 40.
iv. M/s ST Microelectronics (P) Ltd. ITA No. 1806-1807/Del/2008, para 40.
v. M/s CRM Services I (P) Ltd. ITA No. 4068/Del/2009, para 8.1.
vi. M/s Quark Systems (P) Ltd. SB Chd. 41 ITR 606, para 25.
(For the proposition that in a mean situation, differences get evened out).
vii. M/s Bayer Material Sciences P. Ltd. 134 ITD 582, paras 23 and 24.
viii. M/s Capgemini (ITA No. 7861/Mum./2011), para 4.3.6, for the proposition that size matters in manufacturing industry only, and not in service including such as software.
It is also to be noted that Brand/Intangible does not (Per se) make any difference i. M/s Deloiette Consulting (I) P. Ltd. ITA No. 1082/Hyd./2010, para 36. ii. M/s Actis Advisors P. Ltd. ITA No. 5277/Del/2011, para 25.
iii. M/s Wills Processing Service (I) Pvt. Ltd. ITA No. 4547- 4429/Mum./2012, para 45.1 and 45.2 dated 01.03.2013.ITA No. 5637/D/2011 133
Ground 4.8 Resorting to arbitrary rejection of low profit/loss making companies based on erroneous and inconsistent reasons;
Counter:
It is pointed out that there has been no arbitrary rejection of loss makers or low profit makers, and no arbitrary inclusion of high profit makers. The rejection has been on basis of FAR analysis and on account of abnormal circumstances.
Support is found from the following decisions:
i. M/s Wills Processing Services (I) P. Ltd. ITA No. 4547- 4429/Mum./2012, dtd. 01/03/2013, paras 34.4, 34.5, 35.6. In this case they have relied upon, M/s Exxon Mobile (para 34.6), a case also relied upon by the assessee.
ii. M/s Symantec, Mumbai, ITA No. 7894/M/2010, paras 15 and 15.1. iii. M/s B.P. India Services P. ltd. ITA No. 4425/Mum/2010, dtd.
23/09/2011, para 12.
iv. M/s Capgemini India P. Ltd., ITA No. 7861/Mum./2011, dtd.
28/02/2013, para 5.3-4.
v. M/s Actis Advisors P. ltd. ITA No. 5247/D/2011, para 22. vi. M/s SAP Labs India P. Ltd., ITA No. 418/Bang/2008. Order dtd.
30/08/2010, at para 86, it has been held that exclusions have been considered on the basis of FAR analysis also.
86. Now we will consider each comparable.
Accel Transmatic Ltd. : Ld. TPO noticed that this company was finding place in the accept/reject matrix of the tax payer and was rejected in the TP document on the ground that it failed filter of advertising marketing and distribution expenses to sales being less than 3%. Ld. TPO observed that since its software segment qualified all the filters applied by the TPO, the same was ITA No. 5637/D/2011 134 proposed as a comparable but the tax payer did not offer any comments. Ld. TPO observed that only software segment was considered and from the segmental financial submitted by the company, it was clear that it satisfied even the assessee's filter of advertising, marketing and distribution expenses to sales being less than 3%. He, therefore, considered the company as a comparable as it derived its entire software services segment revenue from the software development activities.
87. Ld. Counsel submitted that the company is mainly into development and software products. He submitted that in the following cases this company has been rejected by ITAT:
a. M/s Trilogy E-Business Software India Pvt. Ltd. v. DCIT, Bangalore (ITA No. 1054/BANG/2011 b. M/s Bearing Point Business Consulting Pvt. Ltd. v. DCIT, Bangalore (ITA No. 1124/BANG/2011 c. M/s CSR India Pvt. Ltd. v. ITO, Bangalore (ITA No. 1119/BANG/2011 d. M/s L.G. Soft India Pvt. Ltd. v. DCIT, Bangalore (ITA No. 1121/BANG/2011 e. M/s Transwitch India Pvt. Ltd. v. DCIT, Bangalore (ITA No. 948/BANG/2011 f. M/s HCL EAI services Ltd. v. DCIT, Bangalore (ITA No. 1348/BANG/2011 ITA No. 5637/D/2011 135 g. M/s Logica Pvt. Ltd. v Asstt.CIT, Bangalore (ITA No. 1129/BANG/2011 h. M/s Mercedez Benz Research & Development India Pvt. Ltd. DCIT, Bangalore (ITA No. 1369/BANG/2011 87.1 Ld. Counsel submitted that Accel Transmatic has been specifically rejected on the ground that a software development company cannot be compared with the software product company:
88. Ld. CIT(DR) submitted that in TNMM Method only broad functionality is to be considered. He pointed out that ld. TPO has considered the software service segment only and, therefore, this comparable is not to be excluded.
88.1 We have considered the rival submissions and have perused the record of the case.
89. Ld. TPO has reproduced at page 99 of his order the segmental details from the annual report which separately contains the details of software services. In the cases relied upon by assessee these details were not considered and, therefore, on the basis of those decisions this comparable cannot be excluded. However, we find that in Trilogy E-Business Software India Pvt. Ltd. (supra), as considered in HCL EAI Services (supra), it was, inter-alia, observed in para 49 that this company has related party transactions which are more than permitted level. Ld. TPO has not recorded any finding to this effect. Therefore, as held by us earlier that if RPT is more than 15% than the said company cannot be considered as uncontrolled comparable. We, therefore, restore this issue to the file of Ld. TPO to consider the inclusion/exclusion of ITA No. 5637/D/2011 136 this comparable depending upon the findings on RPT. This issue is allowed for statistical purposes.
B. Avani Cimcom Technologies Ltd. Ld. Counsel for the assessee submitted that this is software product company and hence functionally different. He submitted that the company is mainly into software product development for the travel industry. He submitted that as per the details available on the web site of Avani Technologies, it is evident that the company is involved in provision of software development and IT services. Further, it owns products like Dxchange, travel solution, insurance solution, customer application and relationship management application (CARA), content management system etc. He submitted that segmental details are not available. He relied on the same decisions as for Accel Transmatic Ltd.
90. Ld. DR referred to page 101 of ld. TPO's order and pointed out that as regard assessee's contention that the proposed comparable is a software product company, Ld. TPO referred to the reply received from Avani, wherein it was specifically pointed out that it is a pure software development service provider. Further as per the annual report also there is no presence of software products. He referred to the accounting policy of revenue recognition, wherein it is mentioned that revenue from software development contracts is generally recognized on successful completion of the project or in case of specific contract, the same is accounted as per the terms of contract. Ld. DR pointed out that the word contract implies that it is also software development services and not software product development. Further, it is mentioned that the ITA No. 5637/D/2011 137 company is in Software Development and as such in services sector. He, therefore, submitted that this comparable was rightly selected by ld. TPO. 90.1 We have considered the rival submissions and have perused the record of the case. The company has specifically confirmed in response to information sought u/s 133(6) that it is a pure software development service provider and, therefore, the contention of assessee that it is software product company cannot be accepted particularly when it does not have any revenues from sale of products. Further, as per the information received u/s 133(6) it is clearly stated that this company is in providing software development and consulting IT services to its international clients. It is further stated that it utilized prudent technologies to enable customer's business systems. When this information is read along with the contents of annual report on the web site of this company, we do not find any contradiction Inasmuch as it is also stated that the company is involved in provision of software development and IT services. Ld. counsel's contention that it is a product company is primarily based on the details given on web site that it owns product like Dxchange travel solutions, insurance solutions, customer appreciation and relationship management application, content management systems. These products appear to have been developed by this company for being utilized for business solutions of its clients. Therefore, it is primarily in a software development service sector. The revenues have been derived mainly from software exports. In the case of Trilogy (supra) this company was excluded on the ground of having high operating revenues and details of percentage of exports of products ITA No. 5637/D/2011 138 or services were not available. There is no gainsaying that it is not only the functional profile of a company which is relevant but also the assets utilized by it and risk undertaken. In our opinion, this company being owning certain softwares developed by it, therefore, it was in a better position to cater to the needs of travel sector. This particular asset brought this company in an advantageous position over other software development companies in same sector. The revenue earned by this company was not merely on account of developing a new software from scratch but because of utilization of the owned software by this company. Thus, the asset base of this company could not be compared with tested party. Therefore, we are in agreement with ld. Counsel for the assessee that on account of high operating margins on account of difference in asset base this company cannot be taken as a comparable. In view of above discussion, we direct Ld.TPO to exclude this company from the list of comparables because there is no empirical data on record to identify the contribution towards profitability on account of owned softwares. In the result this issue is allowed.
C. Celestial Labs: Ld. TPO has observed that during the search process for the earlier A.Y. 2006-07 for taxpayers engaged in R&D, this company was finding place as R&D company for the F.Y. 2005-06. But, during the subsequent financial year 2006-07, the company was not finding place as R&D company in the capitaline/provess data base. He noted that as per annual report, the company was categorized as software development service provider. Further, he noted that on the basis of information obtained u/s ITA No. 5637/D/2011 139 133(6), it was evident that the company was mainly a software development service company and it qualified all the filters applied by the TPO. The assessee objected the selection of this comparable on the ground that as per information provided by Celestial Labs under section 133(6), the company is primarily Into development of Software tools as products for application in the field of bio technology, pharmaceuticals & healthcare Industry. It was further pointed out that the software tools developed by celestial lab were proprietary in nature and protected using patent. Thus, it was submitted that this company is product company owning intangible property. The assessee also referred to the annual report wherein it is, inter-alia, stated that the company has developed a de novo drug design tool 'CELSUITE' to drug discovery and protected the IPR by filing under the Copyright / patent Act. It was further pointed out that based on its silico expertise (applying bio-informatics tools), it had developed a molecule to treat leucoderma and multiple cancer and protected the IPR by filing the patent. The company also outlined its future plans in the field of biotechnology. Thus, in sum and substance, the assessee submitted that the company was functionally dissimilar to the assessee as the company was engaged in the biopharma & biotech manufacturing with customized IT Solutions, manufacture of drugs, clinical trials and contract research activities. The assessee relied on same decisions as for Accel Transmatic, noted earlier and also on following decisions in support of its contention that Celestial Lab has been rejected as a comparable:
ITA No. 5637/D/2011 140
Trilogy E business India Software Private Limited, ITA No. 1054/Bang/2011 para 35, Exxon Mobil Company India Private Limited, ITA No. 8311/Mum./2010 para 33 (xi), Quark Systems Private Limited, 32 TTJ 1 (SB) (Chd.), para 25.
91. The assessee further pointed out in the Synopsis that this comparable had been rejected by DRP in the subsequent year i.e. A.Y. 2008-09 from the list of comparable, stating "the company does not meet the employee cost filter and it has been receiving loans from the department of Science & Industrial Research". Ld. Counsel submitted that the same facts hold goods in the current year as well.
92. Ld.CIT(DR) submitted that ld. TPO had issued detailed notice of six pages contained from pages 372 to 378 of appeal set and after considering the response of the company vide its letter dated 29/03/2010, wherein it was categorically stated that the company was mainly providing the services in the field of software development, considered this company as comparable.. Ld. DR further submitted that in the case of M/s Teva Pharma Pvt. Ltd. vs. Addl. CIT (2012-TII-20-ITAT-Mum.-TP), it has been accepted by the assessee that this company is a software development company. In this regard he pointed out that it was noted in this case that the activities undertaken by Celestial Labs were in the nature of providing host of IT related services and some trading activities which are not comparable to the assessee. Therefore, ld. DR submitted that the Celestial Labs is not functionally different. Ld. DR further pointed out that this company was required to give information u/s 133(6) for the following query:
ITA No. 5637/D/2011 141
"If your company is into customization of software, please give the details of revenues by way of software products either purchased from third parties or developed by your own which are used in the customization for the FY 2006-07 and FY 2007-08 respectively. If the software products are purchased by the customs directly from the vendors, please mentioned the same".
In response to this query the company replied as under:
Financial 2006-07 2007-08 Year Revenue 50,75,100 20,21,12,145 from customized Services through inhouse Developed products. Revenue Nil Nil from third party Products Total 50,75,100 20,21,12,145
From this information, the ld. TPO pointed out that the revenue from in house developed products was only to the extent of Rs. 50,75,100/- for FY 2006-07 i.e. only 3.6% of its operating revenues of Rs. 14,12,75,776/-. Thus, more than 75% of revenues were from software development only. He further submitted that as regards assessee's contention that the software products mentioned by the tax payer were used for rendering software development services, Ld. TPO has clarified many software development companies use in house developed libraries/framework for rendering software development services and the presence of these in house developed software tools in no way changes the characteristic of the services as these tools are not sold as a product.
93. As regards the submission of ld. Counsel that in AY 2008-09 this comparable was not taken into consideration as it did not meet the employee ITA No. 5637/D/2011 142 cost, Ld. DR pointed out that the TPO also studied the prospectus filed by the company before SEBI and based on its examination issued notice u/s 133(6) which has been reproduced at pages 105 to 110 of his order and in response to the same, the company pointed out that it was mainly providing the services in the field of software development.
93.1 We have considered the submissions of both the parties and have perused the record of the case.
93.2 There is no gainsaying that it is impossible to find exact replicas of an entity. In a TNMM situation only broad comparability is to be considered. This is the precise reason due to which benefit of (+/-) 5% safe harbor limit has been provided in the Act itself. The minor differences, if any, gets ironed out when mean is calculated. From the submissions noted above, it is evident that Celestial Labs is mainly Into Software Development Services inasmuch as the R&D facilities have been used by it in relation to development of a software for discovery of new drugs. Admittedly, this company was engaged in the bio pharma and biotech Manufacturing on the customized IT Solutions, manufacture of drugs, clinical trials and contract research activities. Thus, the extensive research activity was carried out by this company in order to develop software for specific purposes. The software was for the discovery of new drugs and, therefore, this kind of software development services could not be equated with a normal service provider for various business solutions. This company did not fulfill even the functional comparability criteria. Merely because a company is in software development, does not make it comparable with ITA No. 5637/D/2011 143 tested party divorced of all other considerations. A holistic view has to be taken in such circumstances. If a company is catering to the needs of only particular sector then all the relevant features of that sector have to be given due consideration as the same materially affect the profit margins. This company was owning IPR in respect of Bio Technology and, thus, the software development activities were confined only to this particular field. In our opinion, this company does not come within the broad comparability criteria which is the guiding factor for selection of a comparable also for the reasons given in respect of Avani Cimcon Ltd. We, therefore, accept the assessee's contention that this comparable should not have been selected by ld. TPO. Further, ld. Counsel's submissions that in AY 08-09 this was excluded on the ground of employee cost filter has not been controverted by department.. 93.3 In view of above discussion, we direct exclusion of this comparable from the list of comparables selected by the ld. TPO.
D. KALS Information Systems: Ld. Counsel pointed out that as per the Annual Report, KALS is engaged in the business of software services and software products. Further, at page 17 of the Annual Report it also shows that there is "consumption of software inventory" as expenditure which implies that the company is into trading of software. The assessee relied on same decisions as for Accel Transmatic, noted earlier, and also on following decisions in support of its contention that KALS Info Systems Ltd. has been rejected as a comparable: ITA No. 5637/D/2011 144
Trilogy E business India Software Private Limited, ITA No. 1054/Bang/2011 para 35, Exxon Mobil Company India Private Limited, ITA No. 8311/Mum./2010 para 33 (xi), Quark Systems Private Limited, 32 TTJ 1 (SB) (Chd.), para 25
94. Ld.CIT(DR) referred to page 127 of ld. TPO's order (page 395 of appeal set) and pointed out that in the TP document this company was rejected by observing "Business Review". However, no reasons were given. Ld. DR pointed out that as per the information submitted by the company in response to notice under section 133(6) that it is into two segments viz. software development services and training. The segmental details were also submitted. He pointed out that the conclusion drawn by the TPO that its SWD segment has pre-dominant revenues from software development services only is based on the categorical information furnished by the company. In the information furnished it was pointed out that the use of readymade object libraries were only to the tune of about (0.33 to 3)% in the year of 2005-06 and 2006-07. Further it was pointed out that very small amount of revenues was from domestic training activities contributing between 7% to 8.56% in the year 05-06 to 06-07. Thus, the revenues from software development services constituted more than 88% of the total operating revenues. Ld. DR further pointed out that ld. TPO has only taken the segmental details. As regards the submissions of ld. Counsel regarding consumption of software inventory, Ld. DR clarified that software was bought only for making software. Thus, consumption of software inventory is primarily operating expenditure and has been classified under software development expenditure.
ITA No. 5637/D/2011 14594.1 Having heard both the parties, we find that ld. TPO has primarily been guided by the segmental information obtained by it and not by the results of the company as a whole. Ld. Counsel has relied solely on the annual report but the specific information obtained u/s 133(6) supplements the information contained in the annual report. However, the submission of ld. counsel of anormous difference in the asset base of the two companies cannot be ignored because that certainly has tremendous bearing on profitability of a company. In FAR analysis asset base is one of the important factor for determining the comparability criteria.
95. We, therefore, direct ld. TPO to exclude this company from the list of comparables.
5. E-zest Solutions: Ld. TPO noticed that this company was not finding place in the accept/reject matrix of the assessee. But, the company,s data was available in the Provess Data Base. He pointed out that the annual report for the FY 06-07 was available. But, the functionality was not clear from the annual report and also related party transaction information was not available in the annual report. Therefore, notice u/s 133(6) was issued to the company from which it transpired that the company was engaged in software development services and qualified all the filters applied by the TPO including RPT filters. Ld. TPO, therefore, proposed to include this company as a comparable to the assesse and accordingly, issued show cause notice to assessee. He has pointed out that assessee did not offer any comments and, therefore, this company was considered as comparable. Ld. Counsel referred ITA No. 5637/D/2011 146 to page 386& 387 of paper book, wherein the reply dated 14th September, 2010 contained from pages 317 to 408 is contained to demonstrate that assessee had given specific reply in this regard but the same had not been considered.
95.1 Having heard both the parties, we restore the matter back to the file of ld. TPO to examine the assessee's reply and then decide the inclusion/exclusion of this comparable.
a. Flextronics Software Systems Ltd.: Ld. TPO noticed that this company was finding place in the accept/reject matrix of the tax payer and was rejected in the TP document saying that it failed R&D filter. He observed that based on the information submitted by the company, it qualified all the filters applied by the TPO. From the details of the product revenue submitted by company, it was evident that the same were only 10.8% of the total revenue. He, therefore, proposed to include this company as a comparable to the tax payer. The assessee in its reply pointed out that information obtained u/s 133(6) is in contradiction to the information contained in the annual report. The assessee pointed out that Flextronics claimed that the investment in R&D was only for the purpose of improving the process and did not result in any IPR's whereas from the annual report it was clear that R&D activities resulted in creation of IPR's. Further it was pointed out that the Flextronics had disclosed data from products and services as a composite segment and, therefore, no bifurcation was available between two activities of the company. Ld. TPO referring to the reply received from Flextronics pointed out that company had not created any ITA No. 5637/D/2011 147 unique intangible by incurring R&D expenses. The R&D expenses were incurred only to improve the process. He further pointed out that the software product revenue was 10.87% of the segmental revenues and, therefore, qualified the filter of 75% revenues from software services. In regard to the assessee's submission that there was a thin difference between revenue from services and revenue from products as the contract itself was a single composite contract and it was quite evident that there could be cross subsidizing between the pricing servicing and products at the point of sale, Ld. TPO pointed out that the services segment and product segment were not separately considered as the same were not available. Therefore, the cross subsidizing would cancel as the TPO considered the entire segment of "products and services" and also services contributed more than 75% of the segmental revenue. Ld. TPO further pointed out that the bifurcation between product and service revenues was made available by Flextronics. He, therefore, included this comparable in the list of comparable selected by him. Ld. Counsel submitted that as per the disclosure on segment data in the notes to accounts, the company develops software products and provide software consultancy services for use in the telecommunication industry and also sales telecommunication equipment and provide services on business processes outsourcing. The segment relating to software is combined for software product and services and a brake up has not been provided. He pointed out that in following three cases this company has been excluded by ITAT as the segmental breakup was not available:
ITA No. 5637/D/2011 148
Trilogy E business India Software Private Limited, ITA No. 1054/Bang/2011 para 35, Exxon Mobil Company India Private Limited, ITA No. 8311/Mum./2010 para 33 (xi), Quark Systems Private Limited, 32 TTJ 1 (SB) (Chd.), para 25
96. Ld. Counsel further submitted that the details provided by the Flextronics u/s 133(6) were unreliable and contradictory as on one hand it states that it does not own any IPR for products and on the other its financial details show that it has earned around Rs. 100 crores as software product revenue. Ld. Counsel further submitted that information u/s 133(6) can be an elaboration of the annual report but cannot replace the annual report.
97. Ld.CIT(DR) submitted that the information u/s 133(6) will prevail over the information contained in the annual report. He submitted that the product revenue is around 10% of the total revenue as per the information obtained u/s 133(6).
97.1 We have considered the submission of both the parties and have perused the record of the case.
97.2 For a company to be included in the list of comparables, it is necessary that credible information is available about the company. Unless this basic requirement is fulfilled, the company cannot be taken as a comparable. It is true that ld. TPO is entitled to obtain information us/ 133(6), the object of which is primarily only to supplement the information already available on record, but not, as rightly submitted by ld. Counsel for the assessee, to replace the information. If there is a complete contradiction between the information obtained u/s 133(6) and annual report then the said information cannot be substituted for the information contained in annual report. We, therefore, are in ITA No. 5637/D/2011 149 agreement with ld. counsel for the assessee that this company cannot be included as a comparable in the set of comparables selected by ld. TPO on account of clear contradiction between contents of annual report and information obtained u/s 133(6).
7. Infosys Technologies: Ld. TPO noticed that this company was finding place in the accept/reject matrix of the assessee but was rejected in the TP document on the ground that it failed "business review". He noticed that no reasons were given for rejection on functional grounds or qualitative criteria. He noticed from the annual report that the company was into Software Development Services and qualified all the filters applied by the TPO. The assessee pointed out that the profits derived by Infosys were predominantly due to brand building exercise undertaken by the company. This by itself allowed the company to have a premium pricing for its provision of software services. However, the assessee being a captive service provider, rendering service to its overseas affiliate within a risk insulin was not required to locate brand awareness and thereby a premium pricing. The assessee pointed out that during the relevant financial year, Infosys had a turnover of INR 13,149/- crores whereas assessee's turnover during the year for the software development services was INR680 crores. It was submitted that greater size implies economics of scale and more bargaining power that may impact profitability of a company. It was further submitted that Infosys focuses on R&D as per the annual report. Further Infosys owns product and leverage on its premium banking solution Finacle as is evident from the annual report. Further the company also owns various ITA No. 5637/D/2011 150 products which distinguished the company from the assessee and, therefore, the company cannot be considered as a comparable. Ld. TPO, however, did not accept the assessee's contention and pointed out that as per the assessee's contention the competitive strength of Infosys was due to on account of following factors:
a. Innovation and leadership b. Provess Global Mobile c. Comprehensive and sophisticated solution d. Long standing of the relationships e. States as an employer or choice f. Ability to scale.
97.3 Ld. TPO pointed out that all the above factors are there in the services being rendered by the tax payer to the associated enterprise. If the margins earned by a comparable company are affected by the factors like brand value etc. appropriate adjustments can be made. He pointed out that assessee had not given any cogent evidence or data to support the presumption that the margins earned by Infosys or any other company in the software industry were affected by the so called brand value. He submitted that the ultimate profits earned by any company including Infosys dependent upon the over all market conditions and the services rendered. He demonstrated with reference to final comparable selected by him that brand value had nothing to do with the margin. The said table is reproduced hereunder: ITA No. 5637/D/2011 151
S.No. Company Sales OP to
Name (Rs. Total
Cr.) Cost %
1. Accel 9.68 20.90%
Transmatic
Ltd. (Seg.)
2. Avani 3.55 50.29%
Cimconn
Technologi
es Ltd.
3. Celestial 14.13 58.35%
Labs Ltd.
4. Datamatics 54.51 1.38%
Ltd.
5. E-Zest 6.26 36.12%
Solutions
Ltd.
6. Flextronics 848.66 25.31%
Software
Systems
Ltd. (Seg.)
7. Geometric 158.38 10.71%
Ltd. (Seg.)
8. Helios & 178.63 36.63%
Matheson
Informatio
n
Technolog
y Ltd.
9. IGate 747.27 7.49%
Global
Solutions
Ltd.
10. Infosys 131.49 40.30%
Technologi
es Ltd.
11. Ishir 7.42 30.12%
Infotech
Ltd.
12. KALS 2.00 30.55%
Informatio
n Systems
Ltd. (Seg.)
13. LGS 45.39 15.75%
Global Ltd.
(Lanco
Global
Solutions
Ltd.)
14. Lucid 1.70 19.37%
Software
Ltd.
15. Mediasoft 1.85 3.66%
Solutions
Ltd.
16. Megasoft 139.33 60.23%
Ltd.
ITA No. 5637/D/2011 152
17. Mindtree 590.35 16.90%
Ltd.
18. Persistent 293.75 24.18%
Systems
Ltd.
19. Quintegra 62.72 12.56%
Solutions
Ltd.
20. R S 101.04 13.47%
Software
(India) Ltd.
21. R Systems 112.01 15.07%
Internation
al Ltd.
(Seg.)
22. Sasken 343.57 22.16%
Communic
ation
Technologi
es Ltd.
(Seg.)
23. SIP 3.80 13.90%
Technologi
es &
Exports
Ltd.
24. Tata Elxsi 262.58 26.51%
Ltd. (Seg.)
25. Thirdware 36.08 25.12%
Solutions
Ltd.
26. Wipro Ltd. 9616.09 33.48%
(Seg.)
97.4 With reference to the above table he pointed out that lesser known
companies like Avni Simcom Ltd., Celestial Labs Ltd. & Mega Soft were having almost the same or better margins than Infosys which implies that brand per se does not affect the margins. Similarly he pointed out that Mind Tree Consulted Ltd. and Eye Global Solution Ltd. which have brand value had very thin margins. Thus, he pointed out that brand value has no correlation with the margins earned by a company. He pointed out that assessee did not give any evidence except the margins of Infosys to say that it charges premium over market for its services. Further he pointed out that brand comes with a cost i.e. huge expenses were required to be incurred to build brand value. Thus, a ITA No. 5637/D/2011 153 brand may generate revenue but with a cost compensated any extra benefit, if any derived from such effort. He further pointed out that the brand Infosys or in any other software company improves the ability to sustain earnings into the future with the least risks. Thus, the brand improves the volume of the business with limited risk but not necessarily the margin. Therefore, brand in Infosys improves the volumes but materially does not affect the profitability. Ld. TPO further pointed out that in the case of software industry, the prices for export of software services are usually built in man hours for which the rates are nearly same across the industry for same type of resource in terms of experience expertise as well as functional line. The ld. TPO further pointed out that Infosys was more comparable to the assessee than any other comparable company as it can be treated as conglomerate of captive software service providers as it generate its revenues from long standing customers similar to that of the tax payer. As regards assessee's submission that Infosys incurs huge expenses on R&D expenses, ld. TPO pointed out that Infosys incurred only Rs. 167 crores i.e. 1.3% of total revenues for the FY 2006-07 and, therefore, qualified assessee's own filter of R&D expenses, R&D expenses to sales being less than 3% of revenue. Ld. TPO further pointed out that from the annual report it was evident that Infosys incurred an amount of Rs. 48 crores of its R&D expenses on developing its software product Finacle. Therefore, only 119 crores had been spent in R&D in software development services mainly to improve the processes in delivering software development services. As regards assessee's contention that Infosys had software products, ld. TPO pointed out ITA No. 5637/D/2011 154 that the revenue's from software products were only 538 crores out of total operating revenues of Rs. 13149 crores. Therefore, the revenue from software product constituted only 4.1% of operating revenues. Hence it qualified the filter of more than 75% revenues from software development services. He, accordingly, included this in the list of comparables.
98. Ld. Counsel for the assessee reiterated the submissions made before ld. TPO and pointed out that the Spl. Bench of LG case clearly brings out the importance of brand and marketing intangible in the ramp on transfer pricing.
He submitted that this case clearly lays down that risk bearing activities that compete in the market place need to incur AMP Expenditure to establish and maintain their brand.
99. Ld. CIT(DR) relied on following decisions in support of his contention that brand/intangible does not per se make any difference:
1. M/s Deloite Consulting India Pvt. Ltd., 108/Hyd./2010 (para 36);
2. M/s Actis Advisors Pvt. Ltd., ITA No. 5277/D/2011 (para 25);
3. M/s Wills Processing India Pvt. Ltd., ITA No. 4429 to 4547/Mum./2012 (para 45.1 & 45.2) dated 01/03/2013;
4. M/s Navisite India Pvt. Ltd., ITA No. 5329/D/2012 (para 53 & 54);
5. M/s Cab Gemini, ITA No. 7861/Mum./2011 to contend that economies of scale is relevant for manufacturing sector and not importance for service industry.
100. Ld. Counsel, in the rejoinder, submitted that in the case of Deloite Consulting (supra), ITAT was examining the suitability of one particular ITA No. 5637/D/2011 155 comparable viz. Vishal Information Technology Ltd. viz-a-viz the assessee which was engaged in IT Enabled Services. In this case the assessee itself had chosen VITL as a comparable in its TP Report and letter on sought to exclude on the ground that it had intangible and low employee cost to sales ratio. The Tribunal did not accept the assessee's argument primarily on the ground that "it is not correct on the part of the assessee company to raise a new plea that VITL has low employee cost". The observation regarding intangibles not materially impacting profitability has to be solely seen in the context of the facts of VITL. Therefore, this decision does not lay down the general proposition that intangibles do not matter and do not impact profitability. He submitted that it is a fundamental economic principle that intangibles play a significant rule in any transfer pricing exercise because price and market margin, both vary with the presence or absence of intangibles. He submitted that it is axiomatic that a branded product or services is more expensive than an unbranded product. Significant investment and risk is involved in creating building and maintaining intangibles. He further submitted that section 92B was amended in 2012 to include an extensive definition of intangibles. OECD and UN Guidelines contained extensive reference of intangible in transfer pricing. As far as reliance on the case of Wills Processing was concerned, ld. Counsel pointed out that this case is of no assistance to the revenue as it can be seen from the perusal of para 45.1 of the order, that it was based on the facts of the case. The Tribunal observed that the claim of marketing expenditure being distinguishing factor was not sustainable as the quantum of expenditure was ITA No. 5637/D/2011 156 not material. Similarly, in para 45.2 Tribunal cited the decision in the case of Actis Advisors Pvt. Ltd. to hold that marketing expenditure was not a factor that impacts profitability of software and IT Enabled Services. He pointed out that assessee is not contending that Infosys should be excluded because it incurred high level of marketing expenditure but because it had significant brand which itself had value at more than Rs. 20,000/- crore. Further as per annual report also large profits were derived because of brand.
100.1 We have considered the rival submissions and have perused the record of the case.
101. The earning of profit i.e. that profit margin of an entity depends on several factors such as geographical location of entity, operational efficiency, prevailing market conditions, goodwill of the company, intangibles in the form of brand value of entity , economies of scales, etc.. However, while selecting a comparable for determining the arm's length price of an international transaction, the pre dominant aspect which has to be taken into consideration is the functional profile of the comparable. If a comparable is performing the same functions as the assessee then a further exercise is to be taken regarding assets utilized and risk assumed in carrying out those functions. If the asset base pre-dominantly differs or the risk assumed by a comparable are pre- dominantly different then the said entity has to be excluded from the list of comparables selected for determining arm's length price. Ld. Counsel has relied on the decision in the case of CIT vs. Agnity India Technologies Pvt. Ltd. ITA No. 1204/2011 dated 10/07/2013, wherein the Hon'ble Delhi High Court has ITA No. 5637/D/2011 157 confirmed the decision of Tribunal in excluding Infosys Technologies after taking into consideration following differences:
Basic Particular Infosys Agnity India
Technologies
Ltd.
Risk Profile Operate as Operate at
full-fledged minimal
Risk taking risks
entrepreneurs As the 100%
services are
Provided to
AEs
Nature of Services Diversified- Contract
consulting, Software
Application Development
design, Services.
develop-
Ment, re-
engineering
and
Maintenance
system
Integration,
package
Evaluation and
Implementation
and
Business
process
Management,
etc.
(refer page 117
of
The paper
book)
Revenue Rs. 9,028 Rs. 16.09
crores crores
Ownership of Develops/owns
Branded/proprietary Proprietary
Products products
Like Finacle,
Infosys
Actice Desk,
Infosys
iProwe, Infosys
mConnect,
Also, the
company
derives
Substantial
portion of its
Proprietary
products
(including its
ITA No. 5637/D/2011 158
flagship
Banking
product suite
'Finacle')
Onsite Vs. Offshore As much as The
half of the appellant
Software provides
development Only
Services offshore
rendered by services
Infosys are (i.e.
onsite remotely
(i.e. services from India).
performed
At the
customer's
location
Overseas).
And offshore
(50.20%)
(Refer page
117 of
The paper
book) than half
of
Its service,
income from
Onsite
services.
Expenditure on Rs. 61 crores Rs. Nil (as
Advertising/ the 100%
Sales promotion and Services are
Brand building provided to
AEs)
Expenditure on Rs. 102 crores Rs. Nil
Research
& Development
Other 100%
offshore
(from India)
101.1 Thus, one of the consideration is ownership of branded/proprietary
products . Respectfully following the decision of Hon'ble Delhi High Court, we direct Ld.TPO to exclude this company from the list of comparables taken by TPO.
8. Asian Infotech Ltd.:
102. Ld. TPO noticed that this company was not finding place in the accept/reject matrix of the assessee. He observed that though, as per the data ITA No. 5637/D/2011 159 available in capitaline data base, the company failed employee cost filter of 25% employee cost. However, on the basis of information obtained u/s 133(6), it qualified 25% employee cost filter. The assessee objected to inclusion of this company on the ground that it had related party transaction more than 15% of revenues. The ld. TPO pointed out that since 25% related party transaction filter has been applied and the related party transactions were only to the extent of 22% of the revenues, therefore, it qualifies to be included in the list of comparables. Ld. Counsel pointed out that as per the annual report, the employee cost to sales of the company is 3.96% but on the basis of information obtained u/s 133(6), the company has been considered as a comparable. He further pointed out that high advertisement and marketing expenditure has been spent by this company. He pointed out that the same is 7.72% of sales and 7.82% and the ld. TPO has not commented upon this aspect. He further submitted that notice u/s 133(6) seeking information in the first place had not been sent to Asian and secondly the information has not been shared with the assessee.
102.1 Having heard both the parties, we restore this issue to the file of ld.
AO/TPO for provide the information obtained u/s 133(6) to assessee and thereafter decide the issue denovo.
9. Helios and Matheson Information Technology Ltd.:
103. The ld. TPO noticed that this company was finding place in the accept/reject matrix of the assessee but was rejected in the TP document on the ground that it failed business review. However, no reasons were given for ITA No. 5637/D/2011 160 rejection on functional grounds or qualitative criteria. On the basis of information received u/s 133(6), he observed that the company is into software development services and qualified employee cost filter and all other filters applied by the TPO. Therefore, it was considered as comparable. The assessee was show caused. However, assessee did not offer any comments except saying that the computation of PLI was wrong as dividend income and other income was considered by the TPO. The ld. TPO accordingly, corrected the PLI and included the company as comparable. Ld. Counsel pointed out that the company was engaged in providing services such as application management services, business and technology consultant ITES & BPO services, Maritime practice, etc. Ld. Counsel referred to page 388 of paper book and pointed out following objections were raised by assessee in this regard:
1. This company failed the employee cost/sales filter of more than 25% applied by ld. TPO. However, the company was selected on the basis of information obtained u/s 133(6);
2. The notice u/s 133(6) was not sent to Helois and Mathison and the information obtained was not shared with the assessee;
3. The company's advertising and marketing expenditure to sales ratio was 3.52% and, thus, the company enjoyed a return on account of marketing intangible.
104. Ld. Counsel pointed out that ld. TPO has not dealt with the objections raised by assessee.
104.1 We have considered the submissions of both the parties and have perused the record of the case.ITA No. 5637/D/2011 161
105. As far as assessee's challenge to information u/s 133(6) being in contradiction to the information available in the annual report in regard to employee cost is concerned, we do not find much substance in the same because in the information obtained u/s 133(6) the company must have segregated the information from the annual report and then furnished to the AO.
However, we are in agreement with the ld. Counsel for the assessee that the information obtained u/s 133(6) should have been shared with the assessee. Since the same has not been done, we restore this issue to the file of ld. TPO to examine afresh after dealing with various objections raised by assessee.
10. Lucid Software Ltd.:
106. Ld. TPO noticed that the company was not considered in the accept/reject matrix of the search process given in the TP report. However, the data of the company was available in the data base and also appeared in the search process carried on by the TPO. As per the information obtained u/s 133(6) it was found that the company was a pure software development service company and had no related party transactions. He further observed that the company was not having any revenue from sale of products/licenses as per the contents of annual report. Ld. TPO after considering the assessee's objections, in regard to non inclusion of depreciation amortization recomputed the PLI and included the same in the list of comparables. Ld. Counsel pointed out that the company is a product company focusing on advance Non Destructive Testing (NDT) Technologies. He further pointed out that as per the web site the company is actively involved in research and development with leading ITA No. 5637/D/2011 162 Scientific & Educational Institutions. Further the company has developed proprietary muulam sosftware. In this regard he referred to page 405 to 408 of paper book, wherein the brochure of this software is contained. Further in A.Y. 2008-09 TPO himself has excluded this company as a comparable. In this regard ld. Counsel referred to page 425 of the main appeal set for A.Y. 2008-09 and page 60 of the TP order for AY 2008-09.
107. Ld. DR relied on the order of TPO and submitted that as per the information received u/s 133(6), the Lucid Software is a pure Software Development Service Provider and does not have any revenue by way of sale of product/licenses.
107.1 We have considered the submissions of both the parties and have perused the record of the case. Since this comparable has been excluded by TPO himself in AY 2008-09, we do not find any justification for inclusion of this comparable for AY 2007-08 under the same set of facts and circumstances. No distinguishing feature has been brought on record in regard to this company between A.Y. 2007-08 and 2008-09.
107.2 Accordingly, we direct Ld. TPO to exclude this comparable from the list of comparables.
11. Third Ware Solutions Ltd.:
108. At the time of hearing, ld. Counsel for the assessee did not press exclusion for this comparable from the list of comparables.
12. Siskin Communication Technologies Ltd.:
ITA No. 5637/D/2011 163
109. Ld TPO noticed that the company was rejected in the TP document on the ground that the company fails its filter of business review and R&D to sales was more than 3%. However, no reasons were given for the business review.
109.1 Ld. TPO pointed out that R&D to sales being more than 3% is not acceptable for which detailed discussion has already been made earlier. He further noticed that the company has software services segment and segmental results are available for software services. He further pointed out that on the basis of information obtained u/s 133(6), the company qualifies onsite revenue filter (onsite revenues were to the extent 27.27% of its export revenues). After considering the assessee's reply, ld. TPO included this company in the list of comparables. Ld. counsel pointed out that this company has incurred significant expenditure on research and development activity the same being 6.07% of sales. He further submitted that the company had significant intangible inasmuch as it develops siskin branded products. The company owns IPR Further it was pointed out before TPO that during the year the company had acquired Botnia Hightech F. and its two subsidiaries and thus, it had under gone significant restructuring. However, ld. TPO ignored these facts He relied on the following decisions:
• IQ Information System (I) Pvt. Ltd., ITA No. 1961/Hyd./2012 (para no. 11 & 23, page 25);
• Amerson Process Management India Pvt. Ltd., ITA No. 8118/Mum./2010 (para 16 page 15).ITA No. 5637/D/2011 164
110. Ld. DR relied on the order of TPO and submitted that TPO considered the companies software services segment details only.
We have considered the rival submissions and have perused the record of the case.
111. Ld. TPO has completely ignored the extraordinary business circumstances pointed out by assessee for which necessary adjustment was required to be made in accordance with Rule 10B(3) of Income Tax Rules. However, since this adjustment was not possible, therefore, this company should not have been included in the list of comparables. Further, we find that the company owns IPR and has branded products which also distinguishes it from the assessee and, therefore, keeping in view the decision of Hon'ble Delhi High Court in the case of Agniy India Technologies Pvt. Ltd.(supra), we direct the ld. TPO to exclude this comparable from the list of comparables.
13. Tata Elexi Ltd.:
112. Ld. TPO noticed that the company was rejected in the TP document saying that the company failed its filter of business review and R&D to sales more than 3%. However, no reasons were given for the business review. From the annual report, ld. TPO noticed that this company has two segments one software development and services segment and second systems integration and support segment. Segmental details were available and the company satisfies all the filters. The TPO, accordingly, considered software development and services segment as a comparable. The assessee, inter-alia, pointed out that as per the information received u/s 133(6), it has been specifically provided ITA No. 5637/D/2011 165 that the company is into production of specialized embedded software development services to its customers. Further, the company has termed the services provided by it as unique and non-repetitive in nature involving development of embedded software for use by the customer, whereas in the case of assessee the software development service provided were of routine nature and involved low level coding, testing and documentation services. The assessee further pointed out that in the information obtained u/s 133(6), the company itself has urged not to use the financial of the company for making comparison with the tested party due to the specialized nature of activities performed. The ld. TPO, however, did not accept the assessee's contention and included this company in the list of comparables. Ld. Counsel submitted that in response to notice u/s 133(6), company itself admitted its complex functional profile. He pointed out that the company is into "hardware design".
Further, the company employ wide variety of personnel such as hardware engineers, styling and mechanical designers, graphic designers, and special effect artists. This is ample testimony to the fact that company is not engaged in pure software development activity unlike the assessee. He further submitted that NASSCOM, which is the premium body of IT/ITES Companies in India, also classifies hardware and software designing activity as functionally different to software development activities.
112.1 We have considered the rival submissions and have perused the record of the case.
113. Ld. TPO has observed as under:
ITA No. 5637/D/2011 166
"The taxpayer argues that the company's R&D activities resulted in IPRs. But, the R&D activities resulted only m reusable software components and ready-to-deploy product frameworks developed by technology teams within product design services which are used in delivering the software development services. In fact, this segment is perfectly comparable to the taxpayer as it is also a software development services which uses such software components and ready-to-deploy frameworks which are supplied by the AE I developed by the taxpayer which are assigned to the AE without any compensation. Though the R&D expenses incurred created tools, these tools are not sold to get the revenue for the company but they are used in quick and fast delivery of services to customers. In fact, as discussed under the head "R&D sales > 3%" as above, this filter does not give any indication of functionality of the companies. in the software industry as each company has to be seen in detail whether a company is getting revenue by way of sale of IPRs in the form software products I license fees and whether these IPRs are used by the company internally to improve the delivery of the services. In the later· case, the company is functionally similar. Further, these tools/frameworks are necessary as a company becomes bigger in size as most of the processes had to be standardized to have a control, which becomes difficult in bigger companies. Thus, incurring R&D is a natural process of evolution of a small company into a bigger company, without which the company may not survive. It may fail to deliver the projects in time and also to the satisfaction of the clients. So, in bigger companies many processes are streamlined based on the past experience and converting the same in standardizing in the form of readymade tools. Thus, the presence of R&D expenses is a minor functional difference and does not have material impact on profitability. Thus, as the software development and services segment does not contain any revenue by way of sale of software products/IPRs/license fees, the same is considered as a comparable."
113.1 The submission of ld. Counsel for the assessee that NASSCOM, which is the premium body of IT/ITES Companies in India, has classified hardware and software designing activity as functionally different to software ITA No. 5637/D/2011 167 development activities cannot be ignored. However, since segmental details were available, the objection raised by ld. Counsel cannot be accepted. As far as asseessee's objection with regard to IPR is concerned, we find that the software developed by assessee were used as tool in development of new softwares. This definitely contributed towards higher profits. We have elaborately considered this aspect in earlier part of our order. We, therefore, direct for exclusion of this company from the list of comparables.
14. Wipro Ltd.:
114. Without going in detailed discussion on this issue, we find that in view of the decision of Hon'ble Delhi High Court in the case of Agnity India Technologies Ltd., this cannot be included in the list of comparables.
115. Ground no. 4.10 is with regard to denial of economic adjustment for difference in risk profile.
116. Ld. TPO noticed that in the TP report various risks like market risk, product and technology risk, credit risk and foreign exchange risk were considered. However, no adjustment had been made on account of so called greater risk of the comparable companies as alleged by the assessee.
Accordingly, he issued following show cause notice to assessee:
"First of all, please justify how each of these risks is borne by each of the comparables selected by you. How these risks are greater in comparables than in your case. It is also requested to quantify how each type of risk or the difference in each risk affected the profitability of each of the comparable companies based on the data for the FY 2006-07 or for the years considered by you.ITA No. 5637/D/2011 168
The taxpayer is requested to submit his claim of risk adjustment, if any, including quantification thereof. While submitting the risk adjustment, the taxpayer is requested to submit the basis on which it is computed and also consider the single customer risk political risk and other risks borne by the taxpayer but not by the comparable companies. Unless the taxpayer submits quantification of risk adjustment including single customer risk and political risk in the case of taxpayer, no adjustment would be given on this account."
116.1 Ld. TPO, after detailed discussion, in respect of various risks claimed by assessee, rejected the assessee's claim for following reasons:
1. The tax payer has not given any details regarding the authority of the above method describing CAPM model for adjustment towards risk. It is not clear whether this type of calculation is acceptable in any tax jurisdiction for the purpose of risk premium adjustments. Its acceptability by any renowned and recognized research institution across the world has also not been shown. The manner in which the risk adjustment is computed by the taxpayer is not followed by any country or organization of international repute like OECD. In fact, even the OECD is reluctant to take the risk adjustment as part of the guidelines as there are divergent views on this issue among the member countries of OECD and many countries feel that there is no straight jacket formula for risk adjustment as it depends entirely on the facts and circumstances of the case. Thus risk adjustment is case specific, function specific and also depends on the nature of functions (including risks) carried out by the comparable companies.
2. The tax payer had not given any evidence or argument regarding how the assumptions of CAPM model are true in the case of the AE when it is doing business with the taxpayer.
3. The CAPM model has some weakness, the main being that the model does not recognize the presence of human capital, which is the main driving source for revenues in the software service industry.
4. The taxpayer considered only listed companies. But, there is a method of ITA No. 5637/D/2011 169 computationof similar nature in the index. There is a manner in which unlisted companies beta would be calculated.
5. Wherever market data was not available, the beta is computed based on guideline companies from the small cap and madcap indices of BSE and NSE. But, the risk adjustment should always be based on the comparables selected by the taxpayer or the TPO and not on the other companies, which are not examined and otherwise, not comparable functionally. Thus, the beta of unlisted companies or companies where data was not available should be the average of the beta of the remaining comparable companies.
6. The taxpayer ignored negative risk adjustment in some of the comparable companies. This looks absurd as any risk undertaking enterprise may get a negative return for the risk undertaken and is possible due to the actual realization of risk bringing down the profitability below the risk free rate of return. Thus, its profitability would have been more but for the risk undertaken. Thus, negative risk adjustment has to be considered and cannot be ignored. For example, when the Indian stock markets tumbled in 2007 and 2008, the equity investments given a negative return even though the risk free return is decent. So, it is to ignore negative risk adjustment.
7. The risk adjustment has to be computed based on the risk differential if any, between the taxpayer and the comparable companies. However, the taxpayer ignored weighted cost of capital in the case of taxpayer and risk of the taxpayer in terms of beta.
Effectively, the risk free return would be nullified as there is no difference between the taxpayer and the comparable companies and also the tax payer assumed that its beta is zero, whereas when the return is guaranteed on sales or cost, the beta is not zero as the return on capital fluctuates with revenue.
8. The taxpayer did not consider the differential risk adjustment i.e. it did not considered the weighted cost of capital of comparables to bring it in line with the taxpayer.
9. The beta of a captive software service provider is not zero as the return on capital fluctuates with revenues as the taxpayer is following cost plus method on expenses.
10. As discussed above, the taxpayer bears significant single customer risk and ITA No. 5637/D/2011 170 political/country risk, which may not be compensated adequately by passing on other risks like marketing risks etc. to the parent. Further these risks are not considered in the case of taxpayer while computing the risk adjustment.
11. The taxpayer considered total assets including current assets and current liabilities, but the CAPM hinges upon return on equity or capital employed. The operating assets are the major indictor of capital employed rather than total assets. Operating assets includes fixed assets, trade receivables net of trade payables.
12. The tax payer has assumed that operating expenses of the comparables would not change after risk adjustment. But, after giving effect to risk adjustment, the financial statements of the comparables should look like that of the tax payer i.e., stripping the risk component. So, the expenses pertaining to the risk like sales and marketing expenses, bad debts etc. should be removed from operating expenses and corresponding risk premium adjusted amount has to be reduced from the operating revenues. Hence, as per the above detailed discussion, the computation of risk adjustment by the taxpayer is not acceptable. There is no scientific basis for working out the taxpayer company's beta or beta of the unlisted comparable companies. The taxpayer altogether forgotten that the risk adjustment, if at all to be computed, is to be computed based on the difference between the actual weighted cost of capital of the comparables and weighted cost of capital of the comparable companies assuming same level of equity in the total finances and risk level as evidenced by beta of the taxpayer. This differential is altogether is ignored making the entire exercise redundant."
117. Ld. Counsel submitted that assessee is risk mitigated/insulated/ low risk company and, therefore, in view of the provisions contained under Rule 10B(1)(e) read with Rule 10B(2) and 10B(3)(ii), adjustment was required to be made to the profit margins of the comparables but the same was denied by TPO. Ld. Counsel submitted that assessee had assured orders and, therefore, ITA No. 5637/D/2011 171 a trade off between risk and return had to be drawn. He pointed out that assessee is a captive service provider and, therefore, has none of the following risks:
Market risk, credit risk, technology risk, capacity utilization risk, price risk, service liability risk. He pointed out that as a captive service provider, assessee is insulated from various risks that are borne by independent comparable companies operating as full-fledged entrepreneur companies. The assessee also relied on the US tax code ruling in the case of Westreco vs. Commissioner, 64 TCM 849 (1992), wherein it was held that a captive service provider entity operating on an assured cost plus method does not bear market and other allied risk borne by independent service provider.
117.1 Ld. Counsel submitted that in reply to TPO's show cause notice, the assessee furnished computation of risk adjustment on account of market risk difference following widely accepted method of Capital Asset Pricing Model (CAPM) on the basis of which the amount of adjustment worked out to 6.9% Thus, the mean margin computed by the TPO as the ALP based on his comparables which was 26.71% had to be reduced to 19.8% using the CAPM formula.
117.2 Ld. Counsel submitted that as far as single customer risk, as pleaded by ld. CIT(DR) was concerned, the same was an anticipated risk which is contrary to commercial wisdom. He pointed out that existing risk needs to be accepted not anticipated risk. Ld. Counsel further submitted that the fact that captive software service provider does not bear market and many other risks as ITA No. 5637/D/2011 172 a principle is well recognized and in following cases Tribunal has held that there is difference in risk profile of a captive service provider and full-fledged entrepreneur software development companies that are selected as comparables:
S.No. Case Law Relevant Issue Para No.
(ITAT
Order)
1. Hellosoft The Assessee is a Paragraph
India P. captive service 17
Ltd. Provider. It has Page 17
ITA No. transaction only
645/Hyd/0 With AEs. It is
9 also a fact that
all the
Risk lies with the
AEs. Therefore,
it
Is allowed a
benefit of risk
adjustment
At 1%.
2. M/s Risk factor Paragraph
Cordys actually involved 5
R&D between Page 4
(India) The assessee and
Pvt. Ltd., the Associated
Hyderabad Enterprises has
(ITA No. to be taken into
212/Hyd/0 Account.
6)
3. Sony India ITAT has Paragraph
P. Ltd. vs. acknowledged 132
DCIT the need for
(114 ITD Comparability
448) adjustments on
account
Of research and
development, risk
And working
capital and has
allowed
An adhoc
adjustment of
20%.
4. Mentor ....final set of Paragraph
Graphics comparables may 27 &
(Noida) P. need Page 14
Ltd. To eliminate
ITA No. differences by
196/D/200 making
6 Adjustments for
the following:
a) working
capital
b) adjustment
for risk and
ITA No. 5637/D/2011 173
growth
c) adjustment of
R&D expenses
5. Egain Held that the Paragraph
Communic benefit of 40
ation P. adjustment
Ltd. Was required to
ITA No. be given in
1685/PN/2 working
007 The margin of
profit of the
taxpayer
For not
undertaking any
risk in the
Transactions
involved with its
parent
Company.
6. Philips The Hon'ble Paragraph
Software ITAT has 5.71 (ix)
Centre approved & page
P. Ltd. ITA Adjustment on 170
No. 218 account of risk.
(BNG)/08
117.3 He further pointed out that in Sony India Pvt. Ltd. 114 ITD 448,
Tribunal has approved an ad-hoc adjustment for difference in risk on account of R&D and working capital. Further, in Philips Software Centre (supra), Tribunal approved computation of adjustment on account of difference in risk by looking at the difference between the bank rate (rate at which RBI lends to the bank) and the Prime Lending Rate (PLR) which is the rate at which banks lend to customers. He submitted that matter may go back to ld. TPO before whom assessee will file computation as per CAPM Model duly supported by expert opinion and TPO could rebut the same with an expert opinion.
118. Ld. CIT(DR) submitted as under:-
Ground 4.7 and 4.10 Including certain companies that had extraordinarily high profit margins and hence were not comparable to a low risk captive unit such as the appellant: ITA No. 5637/D/2011 174
Ignoring the business/commercial reality since the assessee is remunerated on an arm's length basis, i.e. it is compensated for all its operating costs plus a pre-agreed mark-up based on a benchmarking analysis, the assessee undertakes minimal business risks as against comaparable companies that are full fledged risk taking entrepreneurs, and by not allowing a risk adjustment to the assessee on account of this fact; and Counter:
It has been established that a captive service provider has all the normal risks and even more, because its entire existence is based on its parent group.
The following case laws are being relied upon:
i. M/s Deloiette Consulting (I) P. ltd. ITa No. 1082/Hyd/2010, para 15, 21 and 40.
ii. M/s Interra Information Technologies (I) P. Ltd. ITA No. 5568/Del/2010, para 76 and 79.
iii. M/s Symantec, Mumbai ITA No. 7894/Mum./2010, para 16.
iv. M/s ST Microelectronics (P) Ltd. 15 ITR Trib. 410 Del, para 40.
v. M/s Wills Processing Service (I) P. Ltd. ITA No. 8772/Mum./2010, para 25, order dt. 7.12.2012.
vi. M/s GE India Technology Centre P. Ltd. ITA No. 789/Bang/2010, para 36.
118. Ld.CIT(DR) submitted that as far as the decision in the case of Philips Software is concerned, the same has been stayed by the Hon'ble Karnataka High Court. He relied on the order of Transfer Pricing Officer and submitted ITA No. 5637/D/2011 175 that Captive Service Provider undertake high risk as against independent service provider. The assessee's AE can shut the business any day and so the assessee will have no work. Thus, there is a high risk in case of a service provider catering to a single customer. Hence there is no assurance of work.
He submitted that assessee claimed an adjustment on account of risk but not considered the risk of catering to a single customer. He submitted that the independent service providers cater to different clients and, thus, undertake risk of realization of dues from them. For this risk they account for in the books of account by way of writing off the bad debts. Thus, impacted the P&L statement by reducing the profits to that extent. He submitted that TNMM requires a broad comparability and, thus, the risk gets mitigated when the margins were computed. He submitted that cost plus 7% is a very low margin to earn. He pointed out that firstly, there must be claim for any adjustment backed by figures and, secondly, it should also be demonstrated that how will the same affect the margins of the assessee. The quantification of risk adjustment should be such as to be easily understandable and not by resorting to complicated methods. Ld. CIT(DR) relied on the decision of ITAT, Delhi Benches in the case of M/s Premier Exploration Services Pvt. Ltd. v ITO 2013-TII-134-ITAT-DEL-TP for the proposition that risk adjustment can be considered when it is demonstrated that comparables had actually undertaken such risks and these materially affected their margin.
ITA No. 5637/D/2011 176118.1 We have considered the submissions of both the parties and have perused the record of the case. We have perused the record of the case. We have also gone through the detailed written submissions filed by assessee from pages 92 to 104 of the written submissions The main contention of assessee is in regard to adjustment on account of market risk by applying CAPM Model. In this regard ld. TPO has observed that the services rendered by the assessee forms a component within the products developed by the assessee. Thus, the associated enterprise incurs marketing for its products and not on the services rendered by the assessee as they are considered in the product sold by the associated enterprise. The relationship between the tax payer and its parent company is exactly the same as that of the independent company and its client in the case of software design and development services. Ld. TPO has observed that it is a fact that the independent enterprises have to bear the vagaries of market conditions. But since the software sector is growing at more than 30% CAGR (Compounded Annual Growth Rate) for the last 10 years, it is not showing or affected by any adverse market conditions. In the absence of adverse market conditions, the assessee has not shown how these market risks borne by the independent enterprises had an effect on the price and, thus, on ITA No. 5637/D/2011 177 the profits during the F.Y. 2005-06. From these findings of ld. TPO, it is evident that he himself is agreeable that market conditions do influence the independent enterprises. Ld. TPO has denied this adjustment mainly on the ground that associated enterprise and other independent comparables are operating on a similar model i.e. one by establishing its subsidiary in low employee cost zone viz. India and the others by outsourcing their activities to other entities operating in India. Ld. TPO has drawn parity between independent comparables and the assessee on this basis. In our opinion, this reasoning cannot be fully accepted particularly because it is not that all the independent comparables are doing only the work outsourced to them by various AEs. This is only a conjecture on the part of ld. TPO. We, therefore, are of the opinion that market risk, if quantifiable, has to be adjusted in view of Rule 10B(1)(e)(iii).
119. Ld. CIT(DR) has submitted that risk of independent comparables gets accounted in its financial statements. There is no denying of this fact and as rightly pointed out in the written submissions by the assessee, this is the reason why the assessee has taken financial statements as the base for computation of risk adjustments. We agree with the submissions of ld. Counsel for the assessee that key risks such as bad debt risk, market risk, contractual risk would factor in the additional return/premium of independent companies for taking such risk in the price it would charge from the third party customer. This ITA No. 5637/D/2011 178 is in line with the generally accepted economic principle that return is proportional to risk. Rule 10B(2)(b) requires the risks of an uncontrolled transaction to be comparable to a controlled transaction to determine the ALP of such a controlled transaction. Rule 10B(3) requires the adjustment to be made for material differences in risk profile. Therefore, risk adjustment has statutory recognition. Ld. TPO carried out alternative analysis after risk adjustment on the basis of CAPM model and worked out the risk adjustment at .73% from the mean PLI of 25% (before working capital adjustment) as against 5.32% computed by assessee in respect of 22 comparables considered by it and 8.99% in respect of comparables proposed by TPO. Ld. TPO observed that .73% difference caused by risk to near PLI was not much so as to require any adjustment. Ld. TPO summarized the risk analysis as under:
15.1.3 "Summary of analysis of risk The discussion on the risk analysis is summarized as under:
• The taxpayer is totally dependent on the AE for business. Thus, the taxpayer takes the risks associated with heavy dependence on a single customer. In common business parlance it is known as 'single customer risk'.
• The cost plus agreement with the AE does not guarantee sufficient volume of business nor period as the agreement is for a period of one year and renewed one year at a time unless terminated otherwise. The agreement can be terminated by any party at any time after giving a stipulated period notice. Thus, the taxpayer is not free from the risk of losing business entirely or losing volume of business.ITA No. 5637/D/2011 179
• The taxpayer is not compensated any amount for termination of agreement even if it is terminated without any cause. No independent enterprise would like to agree for a termination clause without compensation if it is terminated without any cause. • The AE is exposed to the market risk and any fluctuation in the business conditions of the AE affect the contractual terms between the AE and the taxpayer. Thus even if independent comparables undertake some risk, the taxpayer also had to undertake risks like single customer risk, political risk, etc. which are not incurred by the comparable companies and hence the risks are evened out. • There are many captive service providers operating in the same environment as the taxpayer and still earning much better margins than independent risk bearings enterprises and vice versa. Thus, there is no direct correlation between the margins earned and risks taken."
120. Ld. Counsel submitted that in view of the conflicting stand of assessee and ld. TPO, it would be in the interest of justice that keeping in view the complexity of computation of risk factor as per CAPM model, the matter is restored to the file of ld. TPO for computing the value of risk factor as per CAPM model. We agree with this plea keeping in view the fact that there is substantial difference in computation of risk factor embedded in the profitability of comparables between assessee and ld. TPO.
121. We, therefore, in the interest of justice, restore this matter to the file of Assessing Officer/TPO to consider the computation of risk adjustment as per CAPM model by availing the services of technical experts. The experts of the field are to be appointed by both the sides to come to an acceptable conclusion.ITA No. 5637/D/2011 180
122. In the result, this ground is allowed for statistical purposes in terms of aforementioned observations.
123. Ground no. 4.11 was not pressed by assessee as it is general in nature. The assessee has taken an additional ground that ld. TPO/Assessing Officer erred in not following the binding direction of the ld. DRP to exclude Mega Soft Ltd. from the list of comparables chosen for software segment.
123.1 We have considered the submission of both the parties. We find that ld. DRP at page 12 of his order in regard to ground no. 4.11 has observed as under:
"Inclusion of comparables by TPO in CDS sector has been considered by DRP. We find Megasoft should be excluded as it has different financial year end and went under restructuring hence has extraordinary business circumstances. Persistent Systems Ltd. also underwent restructuring. So both are to be excluded as comparables. In case of R Systems assessee has pointed out that the correct margin is 10.09% instead of 15.07%. TPO to verify and adopt correct margin."
124. Ld. Counsel has also pointed out that an application under Section 154 was filed by ld. TPO before ld. DRP which has been rejected. Accordingly, ld. TPO is directed to carry out the directions of ld. DRP.
125. In the result, this ground is allowed for statistical purposes.
126. Now, we will take up grounds relating to Administrative and Marketing Support Services segment of the assessee.
127. The brief description on functions of the company in this segment as under:
"The corporate segment ('CS') is the administrative arm of MIPL. It comprises various teams rendering services that are essentially administrative in nature. Apart ITA No. 5637/D/2011 181 from rendering these services to other segment/business units of MIPL the various teams within CS also provide/receive administrative services to/from various overseas Motorola Group Companies.
The administrative support services rendered with CSC, global vendor of Motorola group companies during the FY 2006-07 are briefly described below:
• Coordination/liasioning with CSC, global vendor of Motorola Group for IT support services and IT systems. The Corporate Segment is required to supervise the personnel provided by CSC for IT system maintenance. • CS is also involved in identification of potential domestic vendors which can provide IT support services to Motorola Group. This role is limited to identifying the vendor and evaluating whether the vendors can meet the broad requirement of the Motorola Group. The decision with regard to hiring the vendor, price negotiation etc., is done solely by the parent company with the potential vendor.
• CS also provides limited HR support and Audit support services to Motorola Group Companies.
Further, MIPL also undertakes limited support services to the Group Companies under. the MDB segment. In respect of this activity, MIP L provides them with inputs on the business opportunities in the Indian Market. It gathers knowledge about the Indian market, requirements of the customers and supplies such information to the Group Companies. For this activity, MIPL is remunerated on a cost plus basis by the Group Companies.
[Unquote]
128. Ld. TPO noticed that assessee had provided administrative and market support services amounting to Rs. 759645791/- to its group companies. The assessee had used TNMM as the most appropriate method and OP/TC as PLI. He further noticed that assessee was showing a profit of 6% in this segment, which, in his opinion, was very low. The Assessing Officer after considering the assessee's reply in respect of various comparables, determined ITA No. 5637/D/2011 182 the PLI at 16.91% and, accordingly, made an adjustment of Rs. 77,844,993/- as under:
Total Cost Rs. 716,355,131/- ALP at a margin of 16.91% Rs. 837,490,784/- Price received Rs. 759,645,791/- Adjustment u/s 92CA Rs. 77,844,993/- 129. Ground no. 5.1 not pressed by the assessee.
130. Apropos ground no. 5.2, ld. Counsel fairly conceded that this ground stands decided against the assessee in numerous cases (Mentor Graphics) (Noida Pvt. Ltd.) 109 ITD 101 (Del.), Customers Services India Pvt. Ltd. vs. ACIT, 30 SOT 486. Accordingly, this ground is dismissed.
131. Ground no. 5.3.1, 5.3.3, 5.3.4 and 5.3.5 were not pressed by assessee at the time of hearing.
132. As far as ground no. 5.3.2 is concerned, this issue has been decided by us while considering ground no. 4.5.3 in regard to software development service segment. Therefore, this ground is partly allowed in terms of observations made therein.
133. As far as ground no. 5.3.6 relating to rejection of assessee's filter of excluding companies having research and development cost to sales being more than 3% is concerned, the said issue has been decided while considering the ground no. 4.5.9 in software development service segment and, therefore, for the reasons stated therein this ground is dismissed. ITA No. 5637/D/2011 183
134. As far as ground no. 5.3.7 is concerned the same relates to advertisement marketing and distribution cost more than 3% filter which was applied by the assessee. This ground has been considered while deciding ground no. 4.5.10 of software development segment and, therefore, for the reasons stated therein this ground is dismissed.
135. As far as ground no. 5.4 is concerned, the same relates to challenge by assessee to TPO's action in including high profit making companies in the final set of comparables for bench marking low risk captive unit such as the assessee. In this regard we may observe that mere high profit margin cannot be a basis for excluding a particular comparable unless it is demonstrated that the profit margin was influenced by certain extraordinary factors or the comparable was not meeting the FAR analysis. As far as the assessee's plea that the profit margins of the company were influenced on account of its being captive unit, we have restored the issue for risk adjustment in the software development segment to the file of TPO after detailed discussion. Therefore, if on account of risk adjustment the profitability of a comparable is to be adjusted then the same is to be adjusted for this segment also.
135.1 In view of the above observation, this ground is allowed for statistical purposes.
136. Vide ground no. 5.5 the assessee has assailed the TPO's action in including certain companies that are not comparable to the assessee in terms of functions performed, assets employed and risks assumed. ITA No. 5637/D/2011 184
137. Vide ground no. 5.6 the assessee has assailed the TPO's action in resorting to rejection of low profit/loss making companies and vide ground no. 5.7 in including certain companies which allegedly are not comparable to the assessee in terms of functions performed, assets employed and risks assumed.
138. Ld. Counsel referred to page 26 of his synopsis and pointed out that assessee coordinates and monitors global support provided by Indian vendors for IT services and IT systems, identifies potential domestic vendors that can provide IT support to the group. The assessee provides limited input on business opportunities in the Indian market.
138.1 Ld. Counsel pointed out that assessee had identified seven comparable companies on the basis of various filters applied by it, the mean of OP/TC margin of which came to 4% as against the margin of 5% declared by the assessee. However, ld. TPO identified 16 comparable companies with the mean margin at 16.91%. Thereafter, ld. TPO excluded VAPI Waste & Management Affluent Company and determined the revised arm's length margin based on 15 comparables at 17.20%. Ld. Counsel referred to page 29 of synopsis and pointed out that the filters selected by assessee were appropriate filters. However, ld. TPO applied following filters:
1) companies with diminishing revenue and consistent losses were eliminated;
2) companies which had more than 25% related party transactions (income as well as expenditure combined) of the operating revenues were excluded; ITA No. 5637/D/2011 185
3) companies with research and development expenditure in excess of 3% of sales were included.
138.2 Ld. Counsel submitted that comparables selected by applying these filters could not be considered. He has assailed various comparables selected by TPO on different grounds which we will consider now. We have already discussed the scope of applicability of above three filters while considering the software development segment. We, therefore, proceed to consider each comparable separately:
1) Genins India TPA Ltd.:
138.3 Ld. Counsel submitted that this company is a third party administrator in health insurance and, therefore, cannot be considered to be in the provision of market support services.
139. Ld. TPO has not established the functional similarity.
139.1 Having heard both the parties, we find that ld. TPO has pointed out from the details provided by the assessee that this company handles customer related queries, pocesses of claims, cashless authorization etc. Therefore, we agree with ld. counsel for the assessee that this company was providing specific services and not market related information. We, therefore direct ld.TPO to exclude this company from the list of comparables. High temp-tech-mat Pvt. Ltd.:
140. The main challenge to the inclusion of this company as comparable is on the ground that the proportion of raw material expenses to total expenses was 31.20% and, therefore, it was not a pure service provider. ITA No. 5637/D/2011 186
141. Ld. TPO pointed out that as per the assessee's reply, it is evident that the business of the company is to provide business consulting services. He further pointed out that the expense details provided by the assessee also showed that the company provided fee based services. He further referred to the details on Prowess Data base to which showed that the company was involved in providing heat treatment services to the rubber/tyre industry. From the aforementioned observations of ld. TPO, it is evident that the assessee's contention regarding proportion of raw material expenses to total expenses being 31.20% being quite significant has not been controverted by ld. TPO and, therefore, this company could not be considered as a pure service provider like the assessee and, therefore, could not be included in the list of comparables.
142. We, accordingly, direct for exclusion of this company from the list of comparable selected by ld. TPO.
2) ICRA Management Consulting Services Ltd.:
143. Ld. Counsel pointed out that it is a multi line management and consulting firm. It has an established track record in consulting and diversified clients based across various sectors and countries. Ld. Counsel referred to page 233 of appeal memo to demonstrate that the services offered by the company are in diversified field such as banking and financial services, corporate advertisery, energy, infrastructure, etc. Thus, he submitted that the company is engaged in high end consulting services and, hence, not comparable.
ITA No. 5637/D/2011 187
144. Ld. CIT(DR) submitted that this company is a rating company, like the assessee, which provides vendor information to the associated enterprise.
145. Ld. Counsel in the rejoinder submitted that there is no comparison between vendor information service rendered by the assessee and the management consulting services rendered by ICR which required much higher degree of skill. Accordingly, the qualities of personnel are also very different. 145.1 Ld. Counsel further pointed out that during 2006-07 ICRA demerged its consulting services subsidiary ICRA Management Consulting Services. Therefore, this was an extraordinary event which had the effect on profitability but was not ascertainable.
145.2 Having heard both the parties, we are not in agreement with ld. Counsel for the assessee that this company is to be excluded on the ground of functional profile because admittedly it was imparting consulting and advisory services. Further, we find considerable force in the argument of ld. Counsel for the assessee that the fact of demerger being an extraordinary event had impact on profitability but this aspect had not been considered by ld. TPO. Ld. Counsel has also challenged the inclusion of this comparable on the ground of expenditure on R&D. In this regard ld. Counsel referred to extracts from annual report to demonstrate that company continuously invests in creating new products and services. Most of the product/service offerings of company involve innovation and original thinking. Further, company also takes steps to register its right over the intellectual property. Therefore, in the the light of the ITA No. 5637/D/2011 188 decision of Hon'ble Delhi High Court in the case of Agnity India Technologies Pvt. Ltd. (supra) also this company cannot be taken as comparable. We, therefore, direct Ld. TPO to exclude this company from list of comparables.
IDC(India) Ltd.:
146. Ld. Counsel submitted that the company is in providing consulting services in Asia Pacific Region. It provides the most rigorous and exhaustive primary research. Further, it also provides services like CMO Advisory Research, Investment Research Serviced, IT Advisory Tools etc. Thus, the company is providing services which are no way comparable to the market support services.
146.1 Having heard both the parties, we find that ld. TPO has only observed that the assessee objected to the inclusion of this comparable on the ground of related party transaction. Thus, the inclusion of this comparable has not properly been considered by ld. TPO and, therefore, we restore this matter to the file of ld. TPO for considering the assessee's objections afresh.
3) IL&FS Eco Smart Ltd.:
147. Ld. Counsel submitted that this company offers services in environmental information processing, GEO - Spatial Solutions, Urban Infrastructure, Solid Based Management, Restatement and Rehabilitations Environmental Management, Environmental Policy interventions and regulations, risk management and environmental capacity - building and training. The services are particularly categorized as environment and social ITA No. 5637/D/2011 189 advisory services, GEO Special Solutions, resource conversation and management etc. management. Thus, company is not comparable to assessee as it is providing diversified services.
147.1 Having heard both the parties, we do not find any reason to exclude this company from the list of comparables because it is not disputed that the company is earning income mainly from advisory and consultancy services. Merely because assessee is providing diversified services, the same cannot be excluded on the ground of functional dissimilarity because the primary function is of imparting consultancy in various fields only. The assessee's challenge on the ground of expenditure on RPT has suitably been answered by ld. TPO.
4) In Macs Management Services:
148. Ld. Counsel submitted that this comparable selected by ld. TPO should be excluded because it is functionally un-comparable inasmuch as the company is engaged in providing placement consultancy services and, therefore, these are not comparable to the assessee's routine administrative and marketing support services. Further, the inclusion of this company is also not warranted on the ground of earning abnormal margin and un-comparable sales turnover. He further submitted that this company has incurred expenditure on advertisement and marketing which exceeds 3% of sales. He further submitted that ld. TPO's observation that assessee had incurred only 2.54% of sales on advertising is incorrect as the assessee is a captive service provider and it does not need to spend on advertising and marketing. Ld. TPO, ITA No. 5637/D/2011 190 however, has not accepted the assessee's contentions for the following reasons:
1) the assessee is also imparting consultancy service like the comparable selected by him;
2) expenditure on advertisement and marketing does not make the company functionally dissimilar;
3) assessee has not pointed out any fact that would lead one to believe that there is some factor in the accounts of the company that makes the profit margin of 38.46% as extraordinary.
148.1 Ld. Counsel pointed out that in the case of M/s Mcicom India Pvt. Limited and M/s Varison India Pvt. Ltd. (ITA Nos. 4187/Del/2010, 2766/Del/2010 & CO 218/D/2010), this company has been rejected on the ground of functional profile being different.
149. Ld. CIT(DR) submitted that the industry verticals must not be looked into for comparability purposes and the assessee has rejected the comparable on the ground of high profitability only.
149.1 Having heard both the parties, we do not find any reason to exclude this comparable from the list of comparables selected by ld. TPO only because of high profit margin earned by the company. Admittedly, the company is imparting consulting services and, therefore, the area in which it is imparting consulting services does not make the company un-comparable unless assessee points out some extraordinary feature resulting into high profit earning ITA No. 5637/D/2011 191 by the company. We, therefore, do not find any reason to exclude this comparable from the list of comparables.
5) Rites Limited:
150. Ld. Counsel submitted that this company is in multi disciplinary infrastructure and engineering consulting services. He pointed out that the services undertaken by the company include:
• Pre project planning involving project identification, feasibility studies and project appraisal;
• Project support activities pricing surveys, environmental and social impact assessment, geo-technical and other investigations;
• Project implementation/management covering contract administration, field engineering and construction supervision, product certification, quality assurance;
• Commissioning, operation, maintenance of rolling cost and work shop management.
150.1 Ld. Counsel further pointed out that this company is a 100% Government Company and such wholly owned company should not be taken as comparables because Government companies often work on considerations other than pure profit.
150.2 He, further pointed out that in the case of M/s Mcicom India Pvt.
Limited and M/s Varison India Pvt. Ltd. (ITA Nos. 4187/Del/2010, 2766/Del/2010 & CO 218/D/2010) this company has been rejected on the ground of functional profile being different.
ITA No. 5637/D/2011 192
151. Ld. DR submitted that the industry verticals must not be looked into for comparability purposes and the assessee has rejected the same on the ground of high profitability only. Ld. DR pointed out that merely because the shares are held by the Government of India does not make the company un- comparable, if the company is functionally comparable. 151.1 We have considered the submissions of both the parties and have perused the record of the case. We find that in the case of Mcicom India Pvt. Limited and others (supra) it has been held as under:
"Marketing support services cannot be compared with turnkey Engineering Services. We agree with the view of the First Appellate Authority that EIL, Rites, Wapsos and TCE are engineering companies and provide end-to-end solutions and whereas the assessee company provides marketing support services to the parent company, which is in the nature of support service and hence not functionally comparable. She rightly concluded that the risk profile is vastly different and hence on this count also they are not comparable." We are in agreement with ld. CIT(DR) that merely because of shares being held by the Government of India, the company cannot be excluded, unless it is established that the company is not functionally comparable. However, we find that assessee was imparting only marketing support services but Rites Ltd. admittedly was primarily imparting turnkey engineering services. Therefore, in view of the observations in the case of M/s MCI com India P. ltd. and others (supra), we direct the ld. TPO to exclude this company from the list of comparables.
8) Technicom-Chemie (India) Limited:ITA No. 5637/D/2011 193
152. Ld. Counsel submitted that this company deals in high-tech machinery and has an excellent set up of company trained service engineers along with suitable spare parts inventory for providing technical support during and after the sales. The areas of operation are as under:
• Solar Energy, pharmaceuticals and health care chemicals infrastructure development.
152.1 Thus, business profile of Technicom is completely different from that of the assessee's administration and marketing support service segment.
153. Ld. TPO did not accept the assessee's contention, inter-alia, observing that from the details provided by the assessee, it is evident that this company coordinates technical tie ups, technical transfer and facilities formation of joint ventures.
153.1 We have considered the submissions of both the parties. This company is primarily a service provider for after sales services and, therefore, cannot be compared with routine consultancy services. This company has earned income from commission, consultancy and services. Further the company is also holding spare parts inventory for providing technical support during and after the sales. Therefore, the business profile of this company is not comparable to assessee which is providing only market support consultancy. We, therefore, direct ld. TPO to exclude this company from the list of comparables.
ITA No. 5637/D/2011 194
9) Wapos Ltd.:
154. Ld. Counsel submitted that this company is engaged in the provision of consultancy services in all facets of water resources, power and infrastructure sectors. Further, the company is a public sector company wholly owned by the Government of India and, therefore, it cannot be compared with the assessee.
154.1 Ld. Counsel further pointed out that in Thyssenkrupp ITA No. 6460/Mum./2012 (para 12.8.1 & 12.8.2), it has been held that Government owned companies should not be taken as comparables as they have social obligations. Further, if they derived income from other Government Companies or agencies, there would further be problem of related party transactions.
155. Ld. DR submitted that this company is purely imparting consultancy services and, therefore, merely because the shares are held by Government of India, it cannot be excluded.
155.1 Having heard both the parties, we do not find ourselves in agreement with ld. Counsel for the assessee for exclusion of this company from the list of comparables. In our opinion, unless it is demonstrated with robust data that because of shares being held by the Government of India, there is impact on profitability of company, the same cannot be excluded merely on the ground of general perception. Further, we find clear cut contradiction in the argument of ld. Counsel for the assessee because the effect of undertaking social obligation by Government Company at best results in reduction of profit and not in increasing the profits. As far as, the decision relied upon by ld. Counsel is ITA No. 5637/D/2011 195 concerned, the same has been rendered having regard to related party transactions but no data has been provided in the present case. We, therefore, uphold the ld. TPO's contention in this regard.
10) Consulting Engineering Services (India) Pvt. Ltd.:
156. Ld. Counsel submitted that this company is engaged in the business of rendering services in diversified areas such as agricultural and rural development, architecture, bridges and structure, roads and highways etc. He pointed out that ld. TPO has not controverted the contention of the assessee.
157. Ld. DR submitted that this company is imparting consultancy services and, therefore, functionally comparable to assessee. 157.1 Having heard both the parties, we do not find any reason to exclude this company from the list of comparables merely on the ground of the company imparting consultancy services in diversified field. Under TNMM method broad comparability is to be considered and if a comparable is horizontally comparable then the same cannot be excluded because of different vertical fields in which it is providing its services.
11) Priya Limited:
158. Ld. Counsel submitted that this company is engaged in the trade of electrical products and export of die stuffs, bulk pharmaceuticals and inter- mediates. The two reportable segments are electronics and chemicals. Therefore, this company is product company and not in consultancy services. 158.1 Having heard both the parties, we find that there is no discussion, in the order of ld. TPO in regard to this comparable and, therefore, we restore the ITA No. 5637/D/2011 196 matter to the file of ld. TPO to examine contentions of assessee and if it is found that the company is trading in products then the same is to be excluded from the list of comparables.
158.2 The comparables chosen by the assessee but not included in the list of comparables selected by ld. TPO.
159. Apropos ground no. 5.7, ld. Counsel submitted that following four comparables chosen by assessee are imparting functions akin to the functions imparted by the assessee:
a. Software experts Ltd.; b. Ask me Infonauts Ltd.; c. Hindustan Housing Company Ltd.; d. Cyber Media Events Ltd. 159.1 Having heard both the parties, we restore this matter to the file of ld.
TPO to examine the assessee's contention denovo viz-a-viz filters applied by him.
160. Vide ground no. 5.8, the asessee is aggrieved with the ld. TPO's action in not allowing risk adjustment to the assessee on account of various factors mentioned in the ground of appeal noted earlier. Both the sides agree that this ground is similar to ground no. 4.10 in regard to software development service segment and, therefore, for the detailed reasons stated therein, we restore this issue to the file of ld. AO/TPO for fresh adjudication.
161. Ground no. 5.9 is general.
162. Vide Ground no. 6, the assessee has assailed ld. TPO's action in not allowing the adjustment in regard to operating profit margins of the comparables ITA No. 5637/D/2011 197 chosen for administrative and marketing support service segment to account for the differences in the working capital levels of the assessee and the comparables. The other two sub-grounds viz. (b) and (c) were not pressed by assessee. In regard to this, ld. Counsel submitted that the binding direction of the ld. DRP in respect of allowing adjustment on account of working capital differences in the operating margins of the comparables should be directed to be followed by ld. TPO.
162.1 Having heard both the parties, we find that while considering ground no. 4.9 relating to working capital adjustment, ld. DRP has directed AO/TPO to grant working capital adjustment based on the OECD formula and by taking 10.25% as the PLR. We, therefore, direct the ld. TPO/AO to carry out the directions given by ld. DRP.
163. In the result, this ground is allowed for statistical purposes. Corporate Issues:
164. Vide ground no.7, the assessee has assailed the order of ld. AO as per the directions of ld. DRP in disallowing provision for liquidity damages amounting to Rs. 201537175/- on the ground that the claim for liquidated damages is a liability of future and not present liability. Further, AO erred in not following the directions of ld. DRP in allowing the reversal of Rs. 306779345/- of the provision for liquidated damages.
165. Brief facts apropos this issue are that AO noticed that assessee had debited provision for liquidated damages amounting to Rs. 201537175/- in its profit and loss account. The AO observed that assessee was engaged, inter- ITA No. 5637/D/2011 198 alia, in the business of installation and commissioning of telecommunication equipments and network and provided technical support services in relation to the same for various telecom operators in India. All these projects were covered under the clause of liquidated damages in accordance with the normal industry practice. He noted that the damages were quantified on the basis of the contractual terms agreed between the parties, and the purchase orders placed by the customers clearly stipulated the amount at which the liquidated damages would be recovered from the assessee for not meeting the delivery dead lines. He further noticed that in case of any delay in the execution/completion of any contract, the assessee becomes liable for damages in terms of the covenants of the purchase order placed by the customers, which was quantified on the basis of the contractual terms and, accordingly, the provision was made. The assessee relied on the decision of Hon'ble Supreme Court in the case of Rotork Controls India Pvt. Ltd., wherein Hon'ble SC held that there are four important aspects of provision:
1. Provision which relates to present obligation;
2. It arises out of obligating events;
3. It involves outflow of resources; and
4. It involves reliable estimation obligation.
166. The AO, however, did not accept the assessee's contentions, inter- alia, observing that the liquidated damages become actual when the assessee is not able to meet the delivery deadlines. The liability does not become real till ITA No. 5637/D/2011 199 then. Therefore, he disallowed the provision for liquidity damages amounting to Rs. 201537175/-.
167. Ld. Counsel submitted that the liquidated damages were part of the sale process and the same was as per the policy of Accounting Standard-29 issued by Institute of Chartered Accountant's of India. 167.1 Ld. Counsel pointed out that ld. DRP did not accept the assessee's contention, inter-alia, observing as under:
"In the instant case, it is an admitted fact that the provisions are made and also written back when no longer required. This indicates that no generalization can be made about liquidated damages. There is a great deal of contingency and it cannot be accurately predicted. Therefore, it would be in the fitness of things to uphold this disallowance. But at the same time the entire reversal of the said provision of Rs. 306779345/- should have been reduced in computing taxable income".
167.2 Ld. Counsel submitted that the assessee is engaged, inter-alia, in the business of installation and commissioning of telecommunication and equipment network and provides technical support services in relation to the same for various telecom operators in India. All the projects executed by the assessee company are done under contracts which contain the clause for liquidated damages in accordance with the normal industry practice. In this regard, ld. Counsel referred to a sample agreement for supply of services between Tata Teleservices (Maharashtra) Ltd. & Motorola India Pvt. Ltd. dated 10/10/2003 contained from pages 798 to 838 of paper book and specifically ITA No. 5637/D/2011 200 referred to page 818, wherein the clause relating to delays and liquidated damages is contained. The same reads as under:
13.2 "The Contractor specifically acknowledges and agrees that time is of essence in the performance of all the Contractor's obligations including, without limitation, the provision of all the Services set forth in this Agreement; 13.3 In the event that Provisional Acceptance of an Equipment, or Element or provision of Equipment is delayed beyond the time schedule specified in the Order, solely for reasons attributable to the Services being Provided by the Contractor, then the Contractor shall be required to pay to TTML an amount of liquidated damages for such delay, calculated on the basis of the price of the delayed portion of the services at the rate of 0.5% per each full calendar week of delay or part thereof subject to a maximum of 5% of the price of the delayed portion of the services. The parties agree that the aforesaid amount is reasonable in light of the anticipated actual harm, which might be caused by any delay to TTML.
13.4 The price of delayed portion described in Article 13.3 of this Agreement shall be the price of the services, which is affected and could not be deployed and be associated with the Network."
167.3 Ld. Counsel submitted that the provision was created on the basis of period of delay in execution of projects and the rate of liquidated damages provided in the contract. Ld. Counsel referred to page 779 of paper book III, wherein schedule 19 to the balance sheet containing notes to accounts is contained, which reads as under:
Provision for liquidated damages Liquidated damages/penalties are provided for wherever there is a delayed delivery attributable to the Company. The provision for liquidated damages are made based on the managements estimates.
Rs. In million Rs. In million Particulars 31 March, 2007 31 March, 2006 ITA No. 5637/D/2011 201 Opening balance 493 171 Add: Provision 202 322 Less: reversals 39 - Less: Utilisations 268 - Closing balance 388 493 167.4 Ld. Counsel further pointed out that usually the assessee enters into discussion/negotiation regarding the quantum of liquidated damages.
Sometimes, the assessee also enters into arbitration proceedings in this regard.
When certainty/finality is reached in respect of the negotiation/discussion/arbitration proceedings with the customers, the relevant amount is shown as utilized from the provision account. In case where the customer agrees to waive the liquidated damages either, partly or fully, the provision is reversed to that extent. This amount is offered to tax as income in the year in which this reversal is done. He further pointed out that this year, the amount of reversal is more than the amount added to the provision, i.e., taxable income of the assessee has gone up on account of the reversal. Ld. Counsel relied on following case laws in support of his contention that provision for liquidated damages is an allowable deduction:
1. Bharat Earth Movers vs. CIT, 245 ITR 428;
2. Delhi High Court in the case of Ericson Communication, 318 ITR 340;
3. KCP Limited, 34 ITD 50 (Hyd.) ITAT Spl. Bench;
4. Madras ITAT in the case of Kaveri Engineering Services, 43 ITD 527;
5. FFE Minerals India Pvt. Ltd. vs. JCIT, 84 TTJ 907 (Chen.) ITAT;ITA No. 5637/D/2011 202
6. Pune ITAT in Thermax Babcock and Willcox Ltd. vs. Addl. CIT, 304 ITR 130;
7. Delhi ITAT in Addl. CIT vs. Ericson India Pvt. Ltd., ITA No. 516/Del/2005.
168. Ld. DR submitted that provision for liquidated damages is actually provision for unliquidated damages because liability has not crystallized. He submitted that unless the damages are crystallized, the same cannot be allowed. He submitted that the deduction for unliquidated damages can be allowed only when the same gets crystallized. The estimation of expenditure and crystallization of expenditure are two separate things. In support of his contention ld. DR relied on following decisions:
1. NSUNDARE SWARAN vs. CIT, 226 ITR 142 (Ker.);
2. Navjevan Roller Floor Pulse Ltd. vs. DCIT, 73 ITD 265.
169. Ld. Counsel in the rejoinder submitted that provision for liquidated damages "and" "unliquidated damages" are two separate concepts. Liquidated damages are such damages as have been agreed upon and fixed by the parties in anticipation of the breach of contract. Unliquidated damages are such damages which are required to be ascertained and/or not fixed by the parties in the contract or agreement and which can be quantified after the matter is settled by the courts. Liquidated damages represent an ascertained liability whereas unliquidated damages represent the liability whose amount is not ascertainable and is to be ascertained in the course of law. 169.1 We have considered the rival submission and have perused the record of the case. Admittedly the contract entered into by the assessee with ITA No. 5637/D/2011 203 its customer contained a specific clause on liquidated damages which define terms and conditions of liquidated damages including the method of calculation as noted earlier. It is not disputed that assessee has created the provision only in those cases where the delay had actually occurred and on the basis of terms and conditions of contract. The terms of contract contemplated that the moment delay occurs in the execution of contract then assessee will become liable for payment of liquidated damages. The liability, thus, crystallized with the occurrence of event of delay in the execution of contract. The assessee might, after entering into negotiation with the party, get a waiver or partial deduction in its liability but that does not absolve the assessee from being liable for liquidated damages on occurrence of the event of delay in execution of the contract.
170. Ld. DR has relied on the decision of Hon'ble Kerala High Court in the case of N.Suderasham. In this case the assessee had entered into contract with foreign buyers for the supply of cashew kernels. However, the assessee could not fulfill the obligations under the contract due to the shortage in the supply of raw cashew nuts and consequent high in prices. Due to the failure to supply the chashew nuts as per the terms of the contract, there was breach of contract and the assessee, therefore, claimed a deduction of Rs. 1251625/- towards damages payable to the foreign companies. The claim was rejected by Tribunal against which assessee preferred appeal which was dismissed as the assessee failed to establish its claim. The Hon'ble High Court, inter-alia, observed that the details regarding the period of contracts, the manner of their ITA No. 5637/D/2011 204 performance, quantification of damages etc. were not specifically brought to their notice. Only the fact regarding arbitration proceedings was brought to the Hon'ble Court's notice. Under these facts, it was held that the damages had not crystallized particularly because there was no stipulation in contract and assessee had denied its liability. In the present, case, however, as noticed earlier, the provision had been made on the basis of specific terms of contract in regard to liquidated damages. Therefore, this decision is of no assistance to the revenue.
171. The next decision relied upon by ld. DR is in the case of Navjeevan Rollar and Floor Ltd. In this case, the assessee company was engaged in the business of manufacturing of dal, besan, suji, etc. On 23/07/1986, the assessee had entered into a contract with a foreign company for the import of yellow gram. Under the contract letter of credit were to be opened latest by 14/08/1986. The assessee, failed to open letter of credit. Protracted litigation ensued. The foreign party claimed damages for breach of the contract. The assessee disputed the payment of damages. There was no stipulation in the contract notes regarding the damages to be paid by the party breaching the terms of the contract. The Arbitrator on 25th May, 1987 awarded certain damages under the arbitration agreement. The assessee challenged the legality of the arbitration award and preferred appeal before the Board of appeal constituted by the Grain and Free Trade Association, which gave decision against the assessee on 20/03/1989. For the A.Y. 1988-89 the assessee claimed deduction on account of damages and certain amount on account of ITA No. 5637/D/2011 205 expenditure for legal fees. The AO allowed the assessee's claim, however, the Commissioner initiated proceedings u/s 263 and set aside the assessment with the direction to the AO to redo the assessment fresh. The AO, ccordingly, made the addition which was deleted by CIT(A) on the ground that the liability on account of damages on breach of contract accrued on 28th May, 1987 when the award of arbitration was passed. The Tribunal upheld the revenue's contention, inter-alia, observing as under:
"The liability for the unliquidated damages was inchoate, uncertain and disputed and the ambit of the dispute was not merely confined to quantification of the damages. The dispute in fact involved the very liability of the assessee to pay any damages to the foreign party. Unless the dispute was finally settled, it could not be said that any liability for payment of damages had accrued or arisen during the year. As held by the Supreme Cout in CIT vs. Hindustan Housing & Land Development Trust Ltd. (1986) 161 ITR 524/27 Taxman 458, an enforceable liability will spring into existence only when it is determined and finally fixed by a court or any other mutually agreed forum. In the instant case on the basis of available materials it was clear that the contract did not provide for payment of any particular amount as damages in case of breach of the contract and the claim by the foreign party was for unliquidated damages."
170.1 Thus, in this case also the provision was not made on the basis of some contractual obligations but on account of Arbitrator's Award which had not become final.
171. From the analysis of the two decisions relied upon by ld. DR, it is evident that both are not applicable to the facts of the case.
172. On the other hand, we find that the case laws relied upon by ld. Counsel for the assessee clearly support the assessee's case particularly because terms and conditions of agreement with customers contained delayed ITA No. 5637/D/2011 206 delivery clause whereunder specified penalty was to be paid by assessee for delay in delivery. We find that Hyderabad ITAT Spl. Bench in the case of KCP Limited, 34 ITD 50 in para 8, inter-alia, observed as under:
8. "As we have noted above, it is not in dispute that in terms of the agreements of the assessee for the supply of goods, time was the essence of the contract and any delay in the delivery of the goods would result in the liability to pay damages. That the parties mean it seriously is proved by the fact of provision for bank guarantee up to the maximum value of liquidated damages. It is also now settled that even contingent liabilities, if properly valued on scientific basis, can be taken into account as trading expenses if they are sufficiently certain and capable of valuation and profits cannot be properly estimated without taking them into account Metal Box Co. of India Ltd. vs. Their Worken [1969] 73 ITR 53 at 64 (SC)]. But, this is not to accept that the provision made for liquidated damages is a contingent liability. The stipulation in the contract clearly shows that the liability for liquidated damages is certain, accrued and is not to depend upon the happening of any event other than delay in deliveries. The only point in dispute in the present case is whether the liability for payment of damages should be taken at the point of time when the breach occurred or at the point of time when the assessee delivered the goods and raised the bill. The distance between these two points of time would made no difference if they happen to be in the same previous year and would make no difference even if they are in two different previous years, as in the present case of a company, the rate of tax is the same. The Revenue insists on the liability being accounted for only at the point of delivery on the ground that there is a likelihood of the claim being made for damages by the other party only at that ITA No. 5637/D/2011 207 point of time, and on the date of breach there was only a unilateral provision for possible claim for damages. This, however, does not seem to be the agreement between the parties, nor even under contemplation. On the other hand, the clause in the agreement extracted above does clearly provide for the payment of liquidated damages no sooner than the delay takes place and as a guarantee for payment of liquidated damages bank guarantee was to be given for the full amount of liquidated damages. There may be a possibility for the deduction of liquidated damages on negotiation.
But that is not to say that the liability to pay liquidated damages did not accrue. Nor does it stand to reason because the delay in the delivery of the goods under the terms of the agreements in question constituted breach, it does not discharge the contract as such, because admittedly the contracts have not been avoided by the other side at all. The reason is that they were continuing contracts for manufacturing of articles to the specification of the purchaser and time was stipulated as the essence of the contract ; nonetheless it would have served no purpose if the purchaser had cancelled the contract when the work on the manufacture of the machinery had progressed perhaps a very large extent and payments were made in the mean time as per the terms of contract. That was the reason why penalties have been provided in the agreement itself depending on the period of delay which is intended to act as a deterrent against delays in deliveries and this is to avoid future litigation as to the quantum of damages. Under section 74 of the Indian Contract Act, even if there is a stipulation by way of penalty, the party complaining is entitled to receive only reasonable compensation not exceeding the amount named. Section 74 reads as follows:
ITA No. 5637/D/2011 208
"When a contract has been broken, if a sum is named in the contract as the amount to be paid in case of such breach, or if the contract contains any other stipulation by way of penalty, the party complaining of the breach is entitled, whether or not actual damage or loss is proved to have been caused thereby, to receive from the party who has broken the contract reasonable compensation not exceeding the amount so named or, as the case may be, the penalty stipulated for."
This shows that the claim for damages arises at the point of breach but the quantification of damages is subject to negotiation, though the ceiling of the amount is stipulated in the contract. As far as the assessee is concerned, the liability to pay damages arose at the point of time when the breach occurred i.e., when it failed to deliver on the due date, and at that point of time the liability accrued which as a prudent trader it could quantify and take into account by means of a provision. Since the agreements have already stipulated the amount, there was nothing wrong in adopting the same formula for computing the amount. All that has happened is since the delay stretched beyond the previous year, the assessee has apportioned the damages and has taken into account only that amount which is relatable to the delay that has occurred in the previous year in question. This is perhaps proper and rational and we can see nothing wrong in this method of accounting either in law or as a matter of method of accounting which has been consistently followed by the assessee, to which no objection was taken by the regular audit as well as by the tax audit. The department does not either dispute the accrual of liability to pay liquidated damages, but in fact it actually allowed the whole amount in the year in which deliveries were given. As we have pointed out above, the contract does not provide for such ITA No. 5637/D/2011 209 a situation, nor does the liability to pay the liquidated damages arise on delivery. Claiming the liquidated damages as and when delays take place is an easier method, and should there be any difficulty in calculations or quantification, that may render the amount provided as damages incorrect but that does not postpone of accrual of liability. As we have pointed out, what was in dispute was the point of accrual of liability under the terms of the contract, but not either quantification or the fact that the liability to pay liquidated damages as and when delays had taken place."
173. Similar view has been taken in other cases also. In the case of FFE Minerals Pvt. Ltd. (supra), while allowing the provision for liquidated damages, inter-alia, observed in para 13 that the decision of Hon'ble Kerala High Court in N. Sudersharam (supra) is not relevant in deciding the issue.
174. We further notice that Pune ITAT in Thermax Bebcock and Wilcox Ltd. (supra) 304 ITR 130 in para 24.5 to para 25, has observed as under:
33. "Having regard to the facts and circumstances of the case and submissions of both the parties, there is no dispute as to the fact that the stipulation providing the payment of liquidated damages to the other party for delay in completing the work, is a part of the contract agreement entered into by both the parties for executing and completing the work. In other words, the condition for payment of liquidated damages for delay in work is in-built in the contract agreement itself. Therefore, there exists an undertaking given by the parties to execute the work within the specified time, the defaulter has agreed to pay damages on account thereof. This undertaking is not found to be conditional.
Thus, this undertaking imported a definite liability on the assessee which accrued as soon as the delay in executing the ITA No. 5637/D/2011 210 works had first occurred and continued till the work was fully completed, though that liability was to be quantified precisely and discharged at a future date. On this aspect, we may again usefully6 refer to a decision of the Hon'ble Supreme Court in the case of Calcutta Co. Ltd. [1959] 37 ITR 1 where the assessee's liability towards undertaking to carry out development work within six months from the date of the deeds of sale was held to have been accrued on the dates of the deeds of sale, though that liability was to be discharged at a future date. In this case the Hon'ble Supreme Court further held that it was an accrued liability, and the estimated expenditure which would be incurred in discharging the same could be deducted from the profits and gains of business and the amount to be expended could be debited in accounts maintained in the mercantile system of accounting before it was actually disbursed, and the difficulty in the estimation thereof did not convert the accrued liability into a conditional one, because it was always open to the income-tax authorities concerned to arrive at a proper estimate thereof having regard to all the circumstances of the case. In this case, the Hon'ble Supreme Court has given emphasis on the assessee's own unconditional undertaking to carry out development works within six months from the dates of the ded of sale whereby the assessee bounded itself absolutely to carry out the same, though the work was to be carried out within six months from the deed of sale. The very undertaking given by the assessee to carry out the development work within six months from the dates of deeds of sale has imported a liability on the assessee which accrued on the dates of the deeds of sale, though that liability was to be discharged at a future date. In this case, the Hon'ble Supreme Court has also pointed out that the taxable income is not on ITA No. 5637/D/2011 211 gross receipts, but on profits and gains of the business. The profits should be understood in its natural and proper sense, in a sense which no commercial man would misunderstand. It has to be real profits. It was for this reason that a deduction of a provision in respect of the liability the assessee had undertaken by way of providing amenities or development work within six months from the date of deed of sale was allowed as a deduction. Applying the same analogy to the present case, we find that the assessee has imported a liability on itself to pay liquidated damages for the delay in completing the work within the specified time, and as such, the estimated expenditure which would be incurred towards liquidated damages would be deductible from the receipts of the year. This certain act or event of not completing the work within stipulated time has imported a definite and absolute liability on the assessee and merely because of the fact that liability would be discharged at a future date and, there is a difficulty in estimating the correct amount thereof would not convert this definite and absolute liability into conditional one as has been held by the Hon'ble Supreme Court in the case of Calcutta Co. Ltd. vs. CIT [1959] 37 ITR 1 (SC), Metal Box Company of India Ltd. vs. Their Workmen [1969] 37 ITR 53 (SC) and Bharat Earth Movers vs. CIT [2000] 245 ITR 428 (SC). In this view of the matter, we may, therefore, say that the reasons given by the AO as well as by the CIT(Appeals) for rejecting the assessee's claim is not in consonance with the principle laid down by the Hon'ble Supreme Court in the case of Calcutta Co. Ltd. vs. CIT [1959] 37 ITR 1 and Bharat Earth Movers vs. CIT [2000] 245 ITR 428 (SC). The very principles laid down by the Hon'ble SC in the case of Calcutta Co. Ltd. vs. CIT [1959] 37 ITR 1 were also followed by the Kerala High ITA No. 5637/D/2011 212 Court in the case of CIT vs. Indian Transformers Ltd. [2004] 270 ITR 259 and the Hon'ble Delhi High Court in CIT vs. Vinitec Corporation P. Ltd. [2005] 278 ITR 337 while deciding the assessee's claim for liability towards warranty clause provided in the sale agreement itself. In this case, it was held that the taxpayer was in the year of sale under an accrued legal obligation to make payments under warranty claims, even further held therein that in computing the profits or gains derived by taxpayer in its business in the year in which the vehicles were sold the tax payer was entitled to deduct from its total income the provision which it had made for the cost of its anticipated liabilities under outstanding warranties in respect of the vehicles sold in that year. In the case of warranty, although it cannot of course be predicted whether any particular vehicle will turn out to be defective or how serious the defect will be, the taxpayer can make a reasonably accurate forecast based on previous experience, of what will be the total cost of remedial work for all the vehicles sold in a given year. In these cases, a view was therefore taken that the anticipated liabilities under unexpired warranties when estimated with reference to statistical information would be a charge on the profit arising from the sale of the goods in respect of which warranty was given and, thus, have to be allowed as deduction. On the issue of claim of deduction on account of warranty in respect of the goods sold in particular year, a reference was also made to the decision of the Privy Council in the case of IRC vs. Mitsubishi Motors New Zealand Ltd. [1996] 222 ITR 697 by the Hon'ble Delhi High Court in the case of CIT vs. Vinitec Corporation P. Ltd. [2005] 278 ITR 337. The Hon'ble Delhi High Court as well as the Hon'ble Kerala High Court in the aforesaid two cases have taken ITA No. 5637/D/2011 213 note of the principles laid down by the Hon'ble Supreme Court in the cases of Calcutta Co. Ltd. vs. CIT [1959] 37 ITR 1and Bharat Earth Movers v. CIT [2000] 245 ITR 428. Therefore, applying the same analogy as applied in the case of warranty by the Hon'ble Kerala High Court's, the Delhi High Court and the Privy Council in the cases of (i) CIT vs. Indian Transformers Ltd. [2004] 270 ITR 259, (ii) CIT vs. Vinitec Corporation P. Ltd. [2005] 278 ITR 337 and (iii) IRC vs. Mitsubishi Motors New Zealand Ltd. [1996] 222 ITR 697 respectively. In the present case can be easily resolved in favour of the assessee. In the present case, the works have been executed after the expiry of the stipulated period. The stipulation as to the payment of liquidated damages towards delay in executing the contract work is related to the contract work, revenue thereof has been accounted for in the year under consideration. Although exact quantification of the claim of liquidated damages may be made at a future date, the assessee payer was, in obligation to pay liquidated damages for the delay in work did accrue on the date when the delay was first occurred and continued upto the date of completion of the work, and thus, in computing the profit and gains derived by the taxpayer from such contract works in the present year, the assessee tax payer is entitled to deduct from the profits from the aforesaid contract works a provision, for the cost of the anticipated liquidated damages in so far as the same is related to the period of delay falling within the year under consideration." 174.1 It has also allowed the assessee's claim of liquidated damages following the decision of Hon'ble Supreme Court in the case of Calcutta Company Ltd. vs. CIT (1959) 37 ITR 1 and Bharat Earth Movers vs. CIT,245 ITR 428 (SC).
ITA No. 5637/D/2011 214
175. In view of above discussion, this ground is allowed for statistical purposes.
176. Apropos ground no. 7.2 ld. counsel submitted that the same has become infructuous because relief has been given to assessee.
177. Ground no. 8 is in regard to disallowance of computer software expenses aggregating to Rs. 1crore 10 lakhs on the ground that these are capital in nature.
178. Brief facts of the case are that the assessee claimed software expenses (pricing of AMC's, Software Purchases with less than one year life and software upgrades) amounting to Rs. 1,10,00000/- as revenue expenditure. The AO disallowed the assessee's claim treating the same as capital expenditure.
178.1 Having heard both the parties, we restore this issue to the file of AO to decide this in the light of guidelines laid down by Spl. Bench of ITAT Delhi in the case of Amway India Enterprises vs. DCIT, 301 ITR 1.
179. In the result, this ground is allowed for statistical purposes.
180. Ground no. 9 was not pressed at the time of hearing.
181. Ground no. 10 deals with non-allowances of TDS and advanced tax credit.
182. Ld. Counsel submitted that assessee has provided original TDS certificates and advanced tax challans to the AO. However, the AO did not allow the credit of TDS and advanced tax while passing the assessment order. Having heard both the parties, we restore this issue to the file of AO to allow the assessee's claim in accordance with law.
ITA No. 5637/D/2011 215
183. Ground no. 11 was not pressed at the time of hearing.
184. Ground no. 12 deals with wrong levy of interest u/s 234C the assessee by way of additional ground has assailed the levy of interest u/s 234C by AO while passing the order u/s 154. The assessee's submission is that interest u/s 234C is to be computed as per the returned income and not as per the asset income. In regard to the submission of ld. DR that in the case of Anjum Gaswalla, Supreme Court it has been held that the interest u/s 234A, 234B & 234C is mandatory, ld. Counsel submitted that the said case law does not deal with the issue as to whether the interest u/s 234C is applicable on returned income or asset income. He, therefore, submitted that the said decision is not applicable in the present case.
184.1 We have considered the rival submissions and have perused the record of the case. We find considerable force in the submission of ld. Counsel for the assessee that as per section 234C, the interest is to be computed with reference to returned income and not assessed income. Accordingly, the AO is directed to compute the interest as per returned income in accordance with law.
185. In the result, this ground is allowed for statistical purposes.
186. While parting, we would like to place on record our deep appreciation for the unrelenting assistance extended by Shri Piyush Jain Ld. CIT(DR) on behalf of Department and the team led by Shri Himanshu Sinha on behalf of the representatives of both the parties, due to which we have been able to assess the legal position as emanating from the innumerable number of cases cited by both the parties.
ITA No. 5637/D/2011 216
187. In the result, the assessee's appeal is partly allowed for statistical purposes.
Order pronounced in the open court on 14/08/2014
Sd/- Sd/-
(DIVA SINGH) (S.V. MEHROTRA)
JUDICIAL MEMBER ACCOUNTANT MEMBER
Dated: 14/08/2014
*Kavita
Copy to:
1. Appellant
2. Respondent
3. CIT
4. CIT(A)
5. DR, ITAT, New Delhi.
TRUE COPY
By Order
ASSISTANT REGISTRAR