Income Tax Appellate Tribunal - Mumbai
General Atlantic Pvt. Ltd., Mumbai vs Assessee on 17 May, 2013
आयकर अपील य अ धकरण "के " यायपीठ मब
ंु ई म।
IN THE INCOME TAX APPELLATE TRIBUNAL "K" BENCH, MUMBAI
ी डी.मनमोहन, उपा य एवं ी पी.एम. जगताप, लेखा सद य के सम ।
BEFORE SHRI D. MANMOHAN, V.P. AND SHRI P.M. JAGTAP, AM
आयकर अपील सं./I.T.A. No. 7638/Mum/2011
( नधारण वष / Assessment Year : 2007-08)
General Atlantic Private बनाम/ The Asstt. Commissioner
Limited, Vs. of Income Tax- (OSD),
17 t h Floor, Circle 3(1),
Express Towers, Aayakar Bhavan,
Nariman Point, M.K. Road,
Mumbai - 400 021. Mumbai 400 020.
थायी ले खा सं . /PAN : AABCG7917Q
(अपीलाथ /Appellant) .. ( यथ / Respondent)
अपीलाथ क ओर से / Appellant by : Shri Porus F. Kaka
यथ क ओर से/ Respondent by : Shri A.K. Jain
ु वाई क तार ख / Date of Hearing
सन : 06-03-2013
घोषणा क तार ख /Date of Pronouncement : 17-05-2013
आदे श / O R D E R
PER P.M. JAGTAP, A.M. :
This appeal filed by the assessee is directed against the order of the Assessing Officer, i.e. Asstt. CIT (OSD) - Circle 3(1), Mumbai dtd. 24-8-2011 passed u/s 143(3) r.w.s. 144-C(13) of the Income Tax Act, 1961 whereby he made addition of Rs. 13,10,03,941/- to the total income of the assessee on account of Transfer Pricing (TP) adjustment.
2. The assessee in the present case is a company which is stated to be engaged in the business of providing investment advisory services. It renders 2 ITA 7638/Mum/2011 services to General Atlantic Service Corporation, USA (GASC LLC). GASC LLC is a Delaware limited liability company which is engaged in providing management services to its affiliated limited partnerships globally. In the process of rendering such services, GASC LLC requires certain information on specific industries along with the information in relation to potential targets located in various jurisdictions. For this purpose, GASC LLC has entered into exclusive service agreements with its wholly owned subsidiary companies based in different countries including the assessee company which is based in India. As per the service agreement, the assessee company collects necessary information to be provided to GASC LLC in relation to the following matters;
(i) the economic and political conditions of India,
(ii) the information technology sectors of the economy of India
(iii) particular information technology enterprises in India
(iv) possible investment opportunities involving information technology enterprises in India.
During the year under consideration, the assessee company received a total amount of Rs. 26,31,02,420/- on account of the services rendered to its holding company GASC LLC as per the service agreement and keeping in view these international transactions of the assessee company with its Associate Enterprise (AE), a reference was made by the A.O. to the TPO u/s 92C(1) of the Act for determining the Arms Length Price (ALP) of such transactions. According to the TPO, the activities of the assessee company were akin to that of investment advisory services and not of routine business support services. Accordingly, he identified eight comparable companies which were forming part of the final comparable set of eight companies taken in the immediately preceding year i.e A.Y. 2006-07. He noted that the average profit margin of the said eight comparable companies was 89.23% as against the mark-up of 12.5% shown by the assessee over and above the total cost. He therefore required the assessee to show cause as to why the average profit margin of 3 ITA 7638/Mum/2011 89.23% should not be considered in its case for determining the ALP of the international transactions with Associated Enterprise (AE).
3. The assessee took a fresh search by using the same parameters and filters, as were used in the last concluded assessment and identified the following additional five comparable companies based on the said search:-
Sl Name of the company Database F.Y 2006-07
No.
1 Agrima Consultants International Prowess 0.69%
Ltd.
2 Crisil Risk & Infrastructure Prowess -22.66%
Solutions Ltd.
3 I C R A Management Consulting Prowess 15.86%
Services Ltd.
4 Mecklai Financial & Commercial Prowess 6.53%
Services Ltd.
5 Rites Ltd. Prowess 31.11%
The above five additional comparables proposed by the assessee were rejected by the TPO on the ground that the final set of eight comparables selected by him in the immediately preceding year was confirmed by the Dispute Resolution Panel (DRP). He also rejected the risk adjustment claimed by the assessee being capital and risk free entity for the detailed reasons given in his order on the basis of which he came to the conclusion that the risk undertaken by independent enterprises is equivalent to the single customer risk undertaken by the assessee. He held that there was thus not much difference in the risk assumed by the assessee and by the comparables to justify any risk adjustment as sought by the assessee. The TPO, however, accepted the stand of the assessee that the single year average operating profit to cost of the eight comparables was actually 68.66% and applying the same to the cost shown by the assessee, the ALP was worked out by the TPO at Rs. 16,04,37,227/- as against Rs. 2,94,33,286/- shown by the assessee. Accordingly, the difference of Rs. 13,10,03,941/- was determined by him as a 4 ITA 7638/Mum/2011 transfer pricing adjustment required to be made to the total income of the assessee in the order dtd. 26-10-2010 passed u/s 92CA (3) of the Act.
4. As per the order passed by the TPO u/s 92CA(3) of the Act addition of Rs. 13,10,03,941/- was proposed by the A.O. on account of T.P. adjustment in the draft assessment order and the same was forwarded by him to the assessee. The assessee raised various objections against the said draft assessment order suggesting the variation in its income with regard to the Transfer Pricing adjustment. Elaborate submissions were made before the DRP on behalf of the assessee in support of its stand on this issue which, as summarized by the DRP, were as under:-
"(i) The taxpayer submitted that the TPO did not understand the correct business profile of the taxpayer.
(ii) The taxpayer, GAPL, is a company registered in the India and belongs to the GA group of companies.
(iii) The taxpayer is a captive service provider for GASC LLC providing investment, management and consultancy services to G.A, Group company, namely, GASC LLC. The Indian company takes limited risks and is remunerated on cost plus mark up basis.
(iv) GAPL gets compensated at full cost plus mark up by GASC LLC for the above services. Its activities are primarily limited to analyzing Investment opportunity, providing recommendations and advice on the basis of Information collected.
(v) GAPL is insulated from all business and operational risks and bears only manpower and general business risk for its operations in India.
(vi) GAPL's profile is clearly distinguished from full fledged entrepreneur which bears all business and market risks and has significant intangibles.
(vii) Hence, GAPL should be characterized a low risk investment provider.
(viii) The coast plus mark up of 12.5%, charged by GAPL to GASC LLC is at arm's length rate.
5 ITA 7638/Mum/2011
(ix) Activities of investment banks, taken by the TPO as comparables, are not good comparables to GAPL.
(x) The AR pointed out that the TPO/Assessing Officer's order suffers from the following infirmities:
- He summarily rejected the comparables identified in the TP report and issued a show cause notice, selecting the final comparables used in AY 2006-07.
- summarily rejected the additional comparables identified by GAPL, based on the re-run of the search undertaken.
- selected the comparables selected by the TPO for AY 2006-07, which were subsequently confirmed by the DRP.
- Rejected the arguments related to adjustment on account of risk, between comparable companies and GAPL.
- Based thereon, the arithmetic mean of comparables was computed at 68.66%, resulting in an adjustment of Rs.13.10 crores.
Erroneous rejection of transfer pricing study.
- TPO grossly erred in rejecting transfer pricing study report prepared by GAPL without providing reasonable basis as required under section 92C(3) of the Act.
- TPO erred In failing to inform GAPL as to how the documentation maintained and the data used in computation of arm's length price is not reliable or correct.
Use of contemporaneous data:
- TPO erred in law by considering data which was not available at the time when GAPL had undertaken the transfer pricing study.
- TPO erred by not allowing GAPL to use multiple year data for computing margin of the comparables.
(xi) The AR contended before the DRP that the TPO relied on the comparables selected for AY 2OO6-O7 without undertaking new search. This cherry picking "Was not acetated to the taxpayer.
The comparables selected by the TPO should be treated as erroneous and not good and worthy comparables.
6 ITA 7638/Mum/2011
(xii) The AR also questioned the action of the IPO in not making adjustment for market risk, for the comparables selected. He stated that GAPL, being the service provider, should be allowed this risk premium.
(xiii) As an alternative methodology, the AR contended the GAPL market risk adjustment should be calculated using CAPM. If risk Adjustment is calculated using CAPM, then the arithmetic mean should be 64.66% instead of 68.66%.
5. After taking into consideration the submissions made on behalf of the assessee as well as the contents of the TPO's order, the DRP proceeded to deal with the objections raised by the assessee. In this regard, DRP referred to the regulations related to the application and use of comparables establishing the ALP and summarized the same briefly in the order as under:-
"(i) The identification of comparable transactions and or companies, to be used in the selection and application of the most appropriate transfer pricing method for the international transactions, is central to the transfer pricing analysis.
(ii) Rule 10(B) of the Income Tax Rules, 1962, provides that the comparability of international transaction, with an uncontrolled transactions, shall be judged with respect to the specific characteristics of the property transferred or services provided in the transaction, or the functions preformed by the respective parties, as evident from an objection FAR analysis, or the contractual terms governing the transaction, or the prevailing market conditions which influence the transactions between the related parties.
(iii) After identification the uncontrolled transactions/comparables, the next step is to undertake a comparability analysis, to ensure that any adjustment achieves results that would have been realized by independent entities in comparable circumstances.
(iv) Any effort to cherry pick comparables, is detrimental to the determination of the ALP.
(v) Rule 10(B) of the Rules states that an uncontrolled transaction/enterprise shall be comparable to an international transaction/enterprise shall be comparable to an international transaction/enterprise, if none of the difference between the two are likely to materially affect the prices or profits and that the two shall be comparable if reasonably accurate adjustments can be made to eliminate the material effects of such differences. Adjustments can be 7 ITA 7638/Mum/2011 made only to eliminate the impact of differences on ALP and not to window dress the cherry picked comparables".
6. Keeping in view the relevant regulations as summarized above and having regard to the facts of the case, the DRP held that the activities of the assessee were akin to merchant banking and investment banking and the eight comparables selected by the A.O./TPO were correct. The DRP also agreed with the TPO in the matter of risk adjustment sought by the assessee and upholding the decision of the TPO on this issue, it held that no interference with the same was called for. The DRP also agreed with the TPO that the assessee was not entitled for +- 5% adjustment in terms of the proviso to section 92 C(2) of the Act. Accordingly directions were given by the DRP to the A.O. u/s 144C(5) of the Act vide order dtd. 16-8-2011 and as per the said directions, final assessment was completed by the A.O. vide order dtd. 24-8-2011 making addition to the total income of the assessee on account of TP adjustment at Rs. 13,10,03,941/-. Aggrieved by the order of the A.O. passed u/s 143(3) r.w.s. 144C(13), the assessee has preferred this appeal before the Tribunal disputing the addition made therein on account of TP adjustment.
7. The counsel for the assessee, at the outset, submitted that a similar set of eight comparables was taken in the case of the assessee by the A.O./TPO for A.Y. 2006-07 and the Tribunal while disposing of the appeal of the assessee for A.Y. 2006-07 vide its order dtd. 31-1-2013 passed in ITA No. 8914/mum/2010 has accepted only one comparable viz. IDC (India) Limited. He pointed out that the profit margin of IDC (India) Limited for the year under consideration i.e. 2007-08 was 15.80% as against the profit margin of the assessee company of 12.6%. He submitted that the assessee, however, is entitled for the benefit of +-5% adjustment as per proviso to section 92C(2) but the Tribunal has not allowed such adjustment for A.Y. 2006-07 on the ground that the comparable price was only one. He contended that the 8 ITA 7638/Mum/2011 decision of the Tribunal on this issue is not acceptable because no opportunity of being heard was given to the assessee on this point while passing the order for A.Y. 2006-07. He contended that the relevant proviso is in two parts out of which one part, which supports the case of the assessee, has not be considered by the Tribunal. He contended that even the amendment made subsequently supports the stand of the assessee on this issue. He further contended that the Tribunal in A.Y. 2006-07 has also not allowed the claim of the assessee for risk adjustment on the ground that no quantification of such adjustment was made by the assessee. In this regard, he invited our attention to the working given at page 213 and 214 of assessee's paper book to submit that keeping in view the said working furnished by the assessee quantifying the risk adjustment, the mater may be sent back to the A.O. for giving appropriate risk adjustment to the assessee after necessary verification. He submitted that the assessee which is dealing with only customer i.e. its holding company has not taken any market risk and this position cannot be disputed. He contended that the IDC (India) Limited, on the other hand, is dealing with third parties and assumes the market risk justifying the claim of the assessee for risk adjustment.
8. The ld. D.R., on the other hand, submitted that only one company viz. IDC (India) Limited has been accepted as comparable by the Tribunal in assessee's own case for A.Y. 2006-07 involving similar facts. He contended that if there is only one comparable price available for TP study, no adjustment of 5% can be allowed as rightly held by the Tribunal in assessee's own case for A.Y. 2006-07. He contended that the proviso to section 92C (2) is very clear in this regard and this position has been accepted by the Tribunal in the case of Haworth (India (P.) Ltd. vs. DCIT (2011) 131 ITD 215.
9. As regards the claim of the assessee for risk adjustment, he invited our attention to the relevant portion of the TP study report furnished by the assessee at page 33 of the paper book to point out that IDC (India) Limited 9 ITA 7638/Mum/2011 (supra) was identified by the assessee company itself as comparable and no risk adjustment was claimed in respect of the said comparable in the TP study report. He contended that although the said claim of risk adjustment was made by the assessee before the TPO for the first time, it could not be allowed when it was not claimed in the TP study report by the assessee company. Reference was made by him to Rule 10B(3) of the Income Tax Rules to contend that the risk adjustment can be made only when there is material differences and adjustment can be accurately made to eliminate such difference. He submitted that there are different types of risks involved in the business and it is very difficult to identify the different risks undertaken by different parties and analyse the same comparatively in order to make accurate adjustment. He contended that eight different risks are identified in the TP study furnished by the assessee itself and it is unimaginable to say that the assessee has not taken any of such risks. He contended that in order to make accurate adjustment on account of risk, the risk profiling of the assessee as well as comparable needs to be carried out, but such exercise has not been done by the assessee. He submitted that neither the Indian law nor even OECD guidelines provides any method for making risk adjustment.
10. As regards the working of risk adjustment furnished by the assessee at page 213 of the assessee's paper book, he submitted that the same is not based on any scientific method. He also pointed out that a similar working furnished by the assessee in support of its claim for risk adjustment has not been accepted by the Tribunal in the case of Wills Processing Services (India) Pvt. Ltd. vs. DCIT in its order dtd. 7-12-2012 in ITA No. 8772/Mum/2010 for A.Y. 2006-07 and in the case of M/s Marubeni India Private Ltd. vide its order dtd. 18-3-2011 passed in ITA No. 809/Mum/2009. Reliance was also placed by him on the decision of Delhi bench of ITAT in the case of Interra Information Technologies (India) Pvt. Ltd. vs. DCIT (ITA Nos. 5568/Del/2010 10 ITA 7638/Mum/2011 & 5680/Del/2011 order dtd. 31-12-2012) wherein the claim of the assessee for risk adjustment on the similar ground was rejected by the Tribunal holding that in the absence of exact details exhibited by the assessee, it is difficult to give any benefit on account of risk adjustment.
11. In the rejoinder, the ld. counsel for the assessee submitted that the decision of the Tribunal in ITA No. 5173/Mum/2012 for A.Y. 2008-09 vide order dtd. 22-2-2013 relied upon by the ld. D.R. in support of the Revenue's case for not allowing the +- 5% adjustment is rendered placing reliance on the another decision of the tribunal reported in 131 ITD 215. He contended that the said decision reported in 131 ITD 215 was rendered with reference to the old proviso to section 92C(2) and amended proviso was not considered.
12. As regards the contention of the ld. D.R. that no risk adjustment was claimed in the TP study report furnished by the assessee, the ld. counsel for the assessee submitted that average margin of three years was taken into consideration in the said TP study report to eliminate the risk and therefore adjustment for risk was not separately made. He submitted that the TPO, however, took only the relevant year data and keeping in view the same risk adjustment was claimed by the assessee. Refering to the relevant portion of the tribunal's order for 2006-07, he submitted that a similar submission was made by the assessee before the Tribunal by submitting that multiyear data should be taken into consideration to eliminate the risk adjustment factor. He submitted that even before the DRP, specific objections were raised by the assessee on risk adjustment by making elaborate submission in the year under consideration, but the DRP has rejected the same in one line without giving any reason whatsoever. As regards the Tribunals' decision relied upon by the ld. D.R., he submitted that the claim of an assessee for risk adjustment therein was rejected for want of relevant information and data while assessee in the present case has furnished all such information and 11 ITA 7638/Mum/2011 data even before the authorities below including the TPO while claiming the risk adjustment.
13. We have considered the rival submissions and also perused the relevant material available on record. It is observed that a set of 8 comparables was taken by the TPO for the TP study in order to determine the ALP of the international transactions of the assessee company with its AEs relying on the assessment for the immediately preceding year in assessee's own case wherein similar set of eight comparables was confirmed by the DRP. As agreed by the ld. representatives of both the sides, the matter as involved in A.Y. 2006-07 has already been decided by the Tribunal accepting only one out of the eight comparables selected by the TPO/DRP namely IDC (India) Limited. Since the facts involved in the year under consideration are similar to A.Y. 2006-07 inasmuch as the set of eight comparables was taken by the TPO relying on the assessment for A.Y. 2006-07, we respectfully follow the order of the Tribunal passed on similar issue for A.Y. 2006-07 and hold that IDC (India) Limited is the only comparable company which is to be taken for the comparable study in order to determine the ALP of the transactions of the assessee with its AEs. The transfer pricing adjustment accordingly has to be recomputed by adopting the op to cost ratio of 15.8% of IDC (India) Limited as against 12.6% shown by the assessee.
14. The ld. counsel for the assessee has raised two issues before us; one relating to assessee's claim for risk adjustment and the other relating to the benefit of +- 5% adjustment as per the proviso to section 92 C(2). As regards the claim of the assessee for benefit of +- 5% adjustment, it is observed that a similar claim made by the assessee in A.Y. 2006-07 has been rejected by the Tribunal vide order dtd. 31-1-2013 (supra) holding that since only one comparable was finally considered for the purpose of determining the ALP, the benefit of +- 5% adjustment in terms of the proviso to section 92 C(2) was not available. A similar view has been taken by the Delhi Bench of the ITAT in 12 ITA 7638/Mum/2011 the case of Haworth (India) (P.) Ltd. vs. DCIT (supra) cited by the ld. D.R. wherein it was held that the proviso to section 92 C(2) of the Act is applicable in a case where more than one price is determined by most appropriate method and in the case where only one price is determined by most appropriate method, benefit of 5% is not available to the assessee. The said decision of the Delhi Bench of ITAT in the case of Haworth (India) (P.) Ltd. (supra) was subsequently followed by the Mumbai Bench of ITAT in the case of IIML Asset Advisors Ltd. (supra) cited by the ld. D.R. wherein it was held that where only one comparable was finally selected by following the appropriate method which was acceptable to both parties and it was possible to compute the ALP on the basis of even one comparable, the assessee would not be entitled to the benefit of 5% range as per the proviso to section 92C(2) of the Act.
15. The contention raised by the ld. counsel for the assessee in this regard is that both the above decisions of Delhi & Mumbai Bench of ITAT were rendered prior to the amendment made in the proviso to section 92C(2) of the Act and therefore effect of the said amendment was not taken into consideration. It is, however, observed that while deciding a similar issue in assessee's own case for A.Y. 2006-07, the Tribunal has duly taken into consideration the proviso to section 92C(2) of the Act as substituted by the Finance (No.2) Act, 2009 as well as Explanation inserted by the Finance act 2012 with retrospective effect from 1-10-2009 and on such consideration, it was held that the language of amended proviso to section 92C(2) of the Act makes it clear that the ALP shall be taken to be in the range of +- 5% of more than one comparable prices and since there was only one comparable considered in the case of the assessee, the benefit under the said proviso would not be available. Respectfully following this decision of the co-ordinate Bench of this Tribunal in assessee's own case for A.Y. 2006-07, we hold that there being only one comparable that is considered in the case of the assessee 13 ITA 7638/Mum/2011 for the year under consideration, the benefit of +- 5%adjustment under the proviso to section 92C(2) of the Act would not be available to the assessee.
16. As regards the claim of the assessee for risk adjustment, it is observed that a similar claim of the assessee was not accepted by the Tribunal in A.Y. 2006-07 on the ground that no quantification of such adjustment was made by the assessee by comparing actual quantitative difference of the assessee with that of the comparables. It was held that such adjustment, in any case, could be made only when some real and accurate effect of the difference in assets employed and risk assumed are brought on record. As submitted by the ld. D.R., IDC (India) Limited was taken as a comparable case in the TP study report submitted by the assessee himself and no risk adjustment was claimed in respect of the said comparable in the TP study. The ld. counsel for the assessee, on the other hand, has submitted that multi-years data was considered by the assessee in the TP study and the average of 3 years margin was taken in the case of IDC (India) Limited to eliminate the difference in risk assumed. We fail to understand how the use of multi-years data and taking the average margin of 3 years can eliminate the difference on account of risk assumed. In our opinion, this method or basis, if at all we can call it so, is not a recognized or scientific method of risk adjustment and by adopting the average of 3 years margin, it cannot be assumed that the assessee has claimed any risk adjustment.
17. The ld. counsel for the assessee has laid great emphasis on the fact that the assessee, who is dealing with only one party which is its AE, has not taken any market risk whereas the IDC (India) Limited, who is dealing with the third parties, has assumed the market risks. It is observed that a similar stand was taken on behalf of an assessee in the case of Interra Information Technologies (India) Pvt. Ltd. (supra) while claiming the risk adjustment on the ground that the assessee was a captive service provider. The Tribunal, however, rejected the said claim holding that being dependent on only one 14 ITA 7638/Mum/2011 source for work is a risk factor to be considered. In the case of Marubeni India Private Ltd. (supra) cited by the ld. D.R., it was reiterated by the Tribunal that the risk adjustment could not be allowed when the assessee failed to bring any evidence on record to show the difference in the risk profile of the comparable companies vis-à-vis the assessee. Since the assessee in the said case had failed to file the details exhibiting the risk borne by the comparable, the Tribunal found it difficult to allow any risk adjustment.
18. The ld. counsel for the assessee has submitted before us that elaborate submissions were made on behalf of the assessee before the TPO as well as DRP, but the same have not been considered by them. A perusal of the order of the TPO, however, shows that the submissions of the assessee on this issue were duly considered and dealt with by the TPO which is evident from para 6.6 of his order which is reproduced below:-
"6.6 The assessee has further sought Risk Adjustment in respect of being a captive risk free entity. The risk adjustment has been computed by way difference in the PLR and the bank rate. As already mentioned assessee is expressed to the same risks as the comparables, if it fails to deliver the goods, it also faces the risk of being closed down, or being out of business. The claim of the assessee is further analyzed as under:
6.6.1 Whether Difference between the bank rate and PLR can determine the Rate of Risk in case of a Non-Banking Business:-
The types and degree of risks an organization may be exposed to depend upon a number of factors such as its size, complexity business activities, volume etc. It is believed that generally the banks face Credit, Liquidity and reputation risks. In a bank's portfolio, losses stem from outright default due to inability or unwillingness of a customer or counter party to meet commitments in relation to lending, trading, settlement and other financial transactions. Credit risk emanates from a bank's dealing with individuals, corporate, financial institutions or a sovereign. For most banks, loans are the largest and most obvious source of credit risk; however, credit risk could stem from activities both on and off balance sheet. In addition to direct accounting loss, credit risk should be viewed in the context of economic exposures.
15 ITA 7638/Mum/2011 The functions performed by business entrepreneur are not present at all in the case of a bank. The taxpayer in the instant case has set up a business in India and therefore it has to be compared with independent business entrepreneurs and not with Banks. The PLR rate reflects the element of risk for loss of capital and also the element of 'Profit of the Bank' to meet the cost of establishment, cost of funds and to give a return on the capital. The difference between Bank Rate and PLR therefore cannot reflect only the return on risk. In any case an entrepreneur other than a Banking company has to face many more risks beside the credit risk.
6.6.2 The assessee has also sought adjustment of risk in respect of risk adjustment under the CAPM Model:
It is often argued by people who value enterprise on the basis of the stock prices, that the risk management is centered in the efficient use of capital alone and that the capital and risks are closely interrelated and an efficient management of one must entail an efficient management of the other. In fact this is myopic disposition of a business function. An enterprise however comprises of a collection of activities that entail risks. To conduct these activities and respond to their risks, the firm needs not just the capital alone, but it has to strategize in variety of ways to respond to the factors which influence its sustenance, growth and profitability, but it has no control over these factors. In other words, it may need capital primarily to fund its operations. to cushion it against adverse financial results, and to assure observers of its financial soundness; but this over emphasis of Capital and its availability is primarily from the investor's point of view which is more myopic than panoramic.
The fact of the matter is - Not all types of risks faced by an entity can be captured purely through Stock Market performance .Thus, risk management may involve the efficient use of capital, but that is not the be all and end all of risk measurement and Risk Management. It is for this reason that the Capital Asset Pricing Model (CAPM) model falls short squarely to measure and manage the risk.
Capital Asset Pricing Model is generally used in investment analysis by economists, investment advisors as well as investment bankers. The CAPM is also often used to measure the performance of mutual funds and other managed portfolios. The CAPM builds on the model of portfolio choice developed by Harry Markowitz's (1959). In Markowitz's model, an investor selects a portfolio at time t-l that produces a stochastic return at t. The model assumes investors are risk averse and, when choosing among portfolios, they care only about the mean and variance of their one-period investment return.
Unrealistic Assumptions of CAP Model 16 ITA 7638/Mum/2011
1. All investors have rational expectations.
2. There are no arbitrage opportunities.
3. Returns are distributed normally.
4. Fixed quantity of assets.
5. Perfectly efficient capital markets.
6. Investors are solely concerned with level and uncertainty of future wealth
7. Separation of financial and production sectors.
8. Thus, production plans are fixed.
9. Risk free rates exist with limitless borrowing capacity and universal access.
10. The Risk free borrowing and lending rates are equal.
11. No inflation and no change in the level of interest rate exist.
12. Perfect information, hence all investors have the same expectations about security returns for any given time period.
The tax payer has not provided any evidence or argument how the above conditions are satisfied in its case. In CAPM, the assumption is that the investor has a choice of wide range of investment opportunities varying from zero risk Government securities to high risk investments such as stocks, mutual funds etc. So, this theory should be used only for investors who have a wide choice of portfolios to invest. However, in the case of tax payer, the parent company's main aim is to reduce cost by outsourcing to India and it is not the case of the parent company that it has unlimited choice for starting various businesses of different risk. The parent company's aim is to outsource its services to India. Here, it does not have any choice but to invest in India in the form of a business concern. So, the CAPM may have limited applicability while taking decision by the parent company to do business in India through its subsidiary.
The CAPM model mainly works on the return on capital employed in the form of equity or debt. It does not recognize the presence of intangibles including human capital. The above model may be a good tool in the industries in which human capital or any other intangible does not play a major role like manufacturing sector. One more problem with the above method is that it uses operating assets constituting fixed and current assets. As mentioned earlier, in the services sectors like financial advisory services, the main strength is its human capital rather than physical assets. Hence, application of CAPM for adjusting risk is not appropriate to research and software sector as this model does not recognize the existence of human capital.
6.6.3. The other factors relating to the risk of the captives are Reduction of Risk for MNCs:-
The contention of the tax payer is that the business risk is borne by the AE and the Indian subsidiary is only a captive service provider with 17 ITA 7638/Mum/2011 minimum risk. However, many studies have been conducted on MNCs setting op their shops across the globe and found that by multinationalising their operations, these MNCs are decreasing the risk. Many studies have been conducted to see how the degree of multinationality produces additional benefits in terms of excess returns or reduced risk and it is found that the degree of multinationality did not have a significant influence on the risk and return performance of the MNCs (Degree of Multinationality and Financial Performance: A Study of U.S.-Based Multinational Corporations by Khursheed Omer, David Durr and Philip Siegel) Single customer risk:
The taxpayer has to bear 'single customer risk' for being a captive service provider, which to a great extent offsets the benefits of taxpayer being not exposed to market risk.
The concept of dealing with a single customer and the inherent risks involved have been discussed by M/s Infosys Technologies Ltd in its audit report for the year 2004-05 as under (page 95):
Client concentration:
We rely on repent business based on the strength of our client relationships and a major portion of our revenues come from existing key clients. As the size of a client increases, it limits our pricing flexibility, strengthens the clients' negotiation capability, and reduces the ability to govern the relationship for mutual advantage. Also, the business growth of these large clients, their own profitability and changes in IT strategy have the potential to adversely impact our revenues and profitability and increase credit risk. However, large clients and high repeat business lead to predictable revenue growth and lower marketing costs. Therefore, to strike a balance, we have chosen to limit the revenue from any single client to a maximum of 10% of total revenue."
Even in the stock market, shares of companies which are heavily dependent upon a very limited number of clients get lesser premium than the shares of the companies having multiple clients' base. Dependence upon a particular client or a particular geography alone is always considered a greater risk. Thus, doing business exclusively with a single client or a single group of clients carries different type of risk and therefore exclusivity clause in any contract is often accompanied by a balancing premium. The taxpayer should also be entitled to a premium on account of single customer risk on the same lines as an independent entrepreneur would claim premium for bearing market risk.
18 ITA 7638/Mum/2011 There are factors at work that actually place a captive service provider in a much higher risk zone. For example, a captive service provider is completely dependent on its associated enterprise and any downswing impact in the business of the associated enterprise could have a severely damaging impact on the captive service provider. Such is not the case with an entrepreneur who has multiple clients arid this diversification actually mitigates risk since a downswing in the business of one client results in a lesser impact on its business as compared to a captive service provider.
Hence, the tax payer's argument that it is compensated adequately for its single customer risk is not correct. If the AE Company goes into liquidation or bankruptcy due to unfavorable economic or other conditions, the business of the tax payer comes to stand still Thus, there is neither the guarantee of assured business/turnover nor of the tenure. The only guarantee is of the return on the cost. So, there is more risk in the case of tax payer who is dependent on a single customer when compared to comparables who may not depend on single customer.
Cost plus arrangement Vs Pricing Risk The taxpayer has a cost plus arrangement, which means benefits of the savings on account of increased efficiency, cost cuttings or increase in turn over etc does not accrue to the taxpayer. It offsets the benefit of not taking the pricing risk.
An independent enterprise gets profit in addition to the costs. The main issue is that the tax payer has not been adequately remunerated on par with the comparables, which is the essence of the transfer pricing i.e. if the tax payer and its AE is perform the functions in uncontrolled conditions, what would have been the margin earned by the tax payer.
As discussed in detail as above the risk undertaken by independent enterprises is equivalent to the single customer risk under taken by the tax payer. Hence, there is not much difference in risks assumed by the tax payer and also by the comparables. So, the argument of the tax payer that the tax payer earns less when compared to its AE is without any basis.
It is no doubt true that the DRP has not passed a well discussed order on this issue. However, the DRP has clearly stated of having agreed with the view of the TPO on this issue thereby adopting the same reasons as given by the TPO to reject the claim of the assessee for risk adjustment.
19 ITA 7638/Mum/2011
19. As regards the quantification of risk adjustment, the ld. counsel for the assessee has invited our attention to the working of risk adjustment furnished by the assessee on page No. 213 of the assessee's paper book which is as under:-
Particulars %
Net cost plus margin of IDC (India) Ltd. % (A) 15.80%
Risk Adjustment for AY 2007-08
Prime Lending rate for F.Y. 2006-07 10.25%
Bank rate for F.Y. 2006-07 6%
Risk adjustment (Prime Lending Rate less Bank 4.25%
Rate)(B)
Risk adjusted net cost plus margin of IDC (C=A-B) 11.55%
Cost plus markup GAPL 12.60%
Result Arm's length
As is clearly evident from the above working, the difference between the prime lending rate and bank rate is sought to be adopted by the assessee as the rate to eliminate the risk difference. As already noted, the claim of risk adjustment of the assessee has been rejected by the Tribunal in A.Y. 2006-07 for want of quantification of such adjustment which, according to the Tribunal, could be possible only when some real and accurate facts of difference in the risk assumed by the assessee and by the comparable are brought on record. The details furnished by the assessee, in our opinion, are hardly sufficient to comply with this requirement. It is also observed that in the case of Wills Processing Services (India) Pvt. Ltd. (supra) cited by the ld. D.R., similar method was sought to be used by the assessee for risk adjustment and the same was rejected by the Tribunal holding that there is no co-relation between the bank lending rates and risks involved as claimed by the assessee. It was held by the Tribunal that all the companies conducting business will have the same risk i.e. market risk, customer risk, government policy risk etc. associated with conducting business. It was also 20 ITA 7638/Mum/2011 held that unless the risk is quantified in certain objective manner and can be represented by way of numbers, it is very difficult to make adjustment on presumptions and surmises.
20. Keeping in view the various decisions of the co-ordinate Bench of this Tribunal as discussed above and having regard to all the relevant facts of the case, we are of the view that the assessee has failed to quantify the risk adjustment by bringing certain real and accurate facts relating to the difference in risk assumed by the assessee vis-à-vis the comparable and in the absence of the same, its claim for risk adjustment cannot be allowed as rightly held by the authorities below. We therefore find no merit in assessee's claim for the benefit of +- 5% adjustment as well as for risk adjustment and reject the same. The A.O. is accordingly directed to recompute the TP adjustment by adopting the cost plus ratio of 15.80% as against 12.6% shown by the assessee.
15. In the result, appeal of the assessee is partly allowed.
प रणामतः नधा रती क अपील आं शक वीकृत क जाती है ।
Order pronounced in the open court on 17-05-2013. .
आदे श क घोषणा खल ु े यायालय म दनांकः 17-05-2013 को क गई ।
Sd/- sd/-
(D. MANMOHAN) (P.M. JAGTAP)
उपा य VICE PRESIDENT लेखा सद य / ACCOUNTANT MEMBER
मुंबई Mumbai; दनांक Dated 17-05-2013.
व. न.स./ RK , Sr. PS
21 ITA 7638/Mum/2011
आदे श क त ल प अ े षत/Copy of the Order forwarded to :
1. अपीलाथ / The Appellant
2. यथ / The Respondent.
3. आयकर आयु त(अपील) / The CIT(A)--13, Mumbai.
4. आयकर आयु त / CIT - -7, Mumbai
5. वभागीय त न ध, आयकर अपील य अ धकरण, मंब
ु ई / DR, ITAT, Mumbai D Bench
6. गाड फाईल / Guard file.
ु ार/ BY ORDER,
आदे शानस
स या पत त //True Copy//
उप/सहायक पंजीकार (Dy./Asstt. Registrar)
आयकर अपील य अ धकरण, मुंबई / ITAT, Mumbai