Income Tax Appellate Tribunal - Kolkata
Itc Infotech India Ltd., Kolkata vs Department Of Income Tax on 9 January, 2015
आयकर अपील य अधीकरण, यायपीठ ""B" कोलकाता
IN THE INCOME TAX APPELLATE TRIBUNAL, "B" BENCH: KOLKATA
(सम ) ी महावीर संह, यायीक सद य एवं ी शामीम याहया , लेखा सद य
Before Hon'ble Sri Mahavir Singh, JM & Hon'ble Sri Shamim Yahya, AM
आयकर अपील सं या I.T.A No. 2222 & 2223/Kol/2010
नधॉरण वषॅ/Assessment Years :2005-06 & 2006-07
D.C.I.T, Circle-2, P-7, Chowringhee V ITC Infotech India Ltd.
Square, Kolkata 37, J.L. Nehru Road, Kolkata-71
PAN:AAACI 7376Q
(अपीलाथ /Appellant) ( यथ /Respondent)
अपीलाथ / For the Department: ी/ ़ Shri Vijay Kumar, CIT-DR
यथ / For the Assessee: ी/Shri
़ Rahul K.Mitra, AR
सुनवाई क तार ख/Date of Hearing: 09-12-2014
घोषणा क तार ख/Date of Pronouncement:09-01-2015
आदेश /ORDER
ी महावीर संह, यायीक सद य Shri Mahavir Singh, Judicial Member:
Both the appeals by revenue are arising out of separate orders of Commissioner of Income Tax [Appeals]-I, Kolkata in appeals No. 496/CIT(A)-I/Cir-2/08-09 & &593/CIT(A)-I/Cir-2009-10 both dated 31-08-2010. Assessments were framed by DCIT, Cir.-2, Kolkata for the AYs 2005-06 & 2006-07 u/s 143(3) of the Income Tax Act, 1961(hereinafter refer to as 'the Act') vide his separate orders dated 29.12.2008 & 29.12.2009 respectively.
2. At the outset, it is seen that both the appeals by revenue are delayed by four days and revenue has filed condonation petition stating the reasons by filing affidavit that almost on the last date the grounds were redrafted, hence there was delay of four days. On the other hand, Ld. Counsel for the assessee has not objected for condonation of delay. In view of the reasons and also concession allowed by Ld. counsel for the assessee, we condone the delay and admit these two appeals for adjudication on merits.
ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 1
3. As regards to the first issue of revenue in both appeals, the revenue has raised identical grounds in both the appeal and issue is also exactly same, hence, we will take up grounds from ITA No. 2222/Kol/2010 and discuss facts and circumstances of the case for both years. The first issue is as under:-
"The first issue in this appeal of revenue is against the order of CIT(A), in deleting the addition made by AO on the basis that transfer pricing adjustments proposed by TPO, holding that risk factors involved in transactions carried out on the basis of contracts either by assessee himself or through subsidiaries are same and no transfer pricing adjustment is to be made in the given facts and circumstances."
For this following are three grounds in revenue's appeals:-
1. That on the facts and in the circumstances of the case the Ld. CIT(A) erred in adjudicating that risk factors involved in contracts - direct and through subsidiaries are same, though it is higher in the former type and is thus entitled to larger share of proceeds.
2. That on the facts & circumstances of the case the Ld. CIT(A), by deleting the transfer pricing adjustment of Rs.62588125/-, failed to appreciate that arms length pricing adjustment was not arbitrary but is a bench mark determined on similar instances.
3. That on the facts & circumstances of the case the Ld. CIT(A) erred in opening that shifting of profits is not a possibility as assessee enjoys tax benefits in India as in terms of provisions of section 92C(4), adjustment can be made in ALP even if assessee enjoys tax benefits.
4. Facts relating to above issue are that the assessee, i.e. ITC Infotech india Limited (hereinafter referred to as 'the assessee'), entered into international transactions with its Associated Enterprises (hereinafter referred to as 'AEs'). The assessee with the marketing support of its AEs is engaged in the business of Information Technology services. It undertakes customized software solution development, IT facilities management and provides professional IT services to several clients across the globe. Its software development centres are based in Bangalore and Kolkata. During the relevant assessment years 2005-06 & 2006- 07 relevant to financial years 2004-05 & 2005-06 the Transfer Pricing Officer (hereinafter referred to as 'the TPO') proposed transfer pricing adjustments and consequently confirmed by the Assessing Officer. The TPO made adjustments in relation to payments on account of Accounting Management Charges by the assessee to its subsidiaries ITC Infotech (USA) Inc. USA (hereinafter referred to as 'I2A') and ITC Infotech Limited, UK (hereinafter referred to ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 2 as 'I2B'). According to the assessee, TPO made adjustments by altering the revenue sharing model without fully appreciating the functional and risk profile of the assessee and its AEs along with the global business model followed by them.
5. The assessee explained before TPO, AO, CIT(A) and before us also that the assessee is a wholly owned subsidiary of ITC Limited, having two wholly owned subsidiaries 12A and 12B. Now before us Ld. Counsel for the assessee Sh. Rahul K Mitra explained business structure of the assessee and functional profile of the AEs. The assessee is structured into four Clusters comprising of various business Verticals and Technology Horizontals. The clusters offer enhanced customer value through superior and combined leverage of technology and business skills. He explained Transfer Pricing documentation of the assessee. Based on the functional and risk profile of the assessee and its AEs, the AEs were selected as tested parties for application of the most appropriate method and determination of the arm's length nature of international transactions between the entities. The Transfer Pricing report maintained by the assessee is enclosed in assessee's paper book at page 42 & at page 114 for AY 2005-06 & AY 2006-07 respectively), which explains these aspects in detail along with the economic analysis to conclude arm's length nature of respondent's international transactions with its AEs. He explained that the assessee and its AEs operate under an integrated 'Global Delivery model' which was explained before TPO and CIT (A). The functions of various group entities performed while targeting, negotiating and winning customer contracts are summarised at page 638 & at 220 to 221 of assessee's Paper Book for AY 2005-06 & AY 2006-07 respectively. He explained that customers based on their individual preferences and requirements, chooses to enter into contract with I2A/12B or directly with assessee which does not make any essential variation in sharing of functions and risks between the assessee or its AEs. He then referred to the Master Service Agreement ( in short 'MSA') between the assessee and its AEs. According to him the assessee entered into separate MSA with its AEs for defining the sharing of functions and responsibilities between the assessee and its AEs, as well revenue sharing model. As per the executed MSA, services to be rendered by parties (the assessee and its AEs) have been summarised by assessee in its written submissions, which are as below:-
" Administrative Services ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 3 Administrative services refer to customer account management and other administrative activities to be performed by the subsidiaries pursuant to the customer contract. The detailed nature of the administrative functions to be performed is provided in the MSA.
Non-administrative services The non-administrative services refer to the activities and services other than the administrative services to be performed by the respondent under the contract which includes customization of software solution development, implementation and support of IT systems and solutions. IT facilities management services and other IT services which may be defined by the customers"
Ld. Counsel explained that as per MSA 12A of 12B subcontracts the provision of non- administrative services to the assessee, it would receive a fee equal to 75% of the revenue derived under the contract and when the assessee subcontracts certain obligations relating to the provision of administrative services to its subsidiaries, it would pay a fee equal to 25% of the revenue derived under contract. Further, it has been specifically provided in clause 4B(iv) of the MSA between the assessee and 12A and clause 4B(v) of the MSA between the assessee and 12B that the provider of actual services shall bear full responsibility for delivery of all Non-Administrative Services provided to a customer and shall be fully liable to other entity for the same. It is also provided in clause 4A(iv) of the MSA between the assessee and 12A and clause 4A(iv) of the MSA between the assessee and 12B, that the services provided by 12A / 12B pursuant to clause 4A will be limited to administrative services and that, in such circumstances, 12A / 12B will not be liable or responsible for the delivery of services other than administrative services. Hence in case of split revenue contract, party who receives 75% share shall bear full delivery risk for non-administrative services and party who receives 25% share shall only be responsible for administrative services. He also explained that the basic functions of 12A or 12B would be to perform marketing activities and undertake the administrative functions i.e. account management services.
6. The assessee also explained invoicing arrangement that to effectively cater to requirements of overseas customers, the assessee has streamlined its invoicing arrangements with 12A / 12B into the following two categories:-
Arrangement 1: The customer directly enters Arrangement 2 : The customer directly into contract with the respondent enters into contract with 12A and 12B ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 4 Customers Customers Pays USD 100 to the Pays USD 100 to 12A/12B respondent for provision of for provision of software software development development services services Retains Retains 75% 25% 12A/12B Performs Respondent administrative Performs software services development service (non- Pays USD 75 to the respondent for administrative) software development services (non-
administrative)
Pays USD 25 to
12A/12B Retains 75% Respondent
For administrative Performs software
services development services
Retains
25% 12A/12B Performs
Administrative
services
A detailed explanation of the above invoicing arrangement has been enclosed at page 640 & 217of the assessee Paper Book for AY 2005-06 and AY 2006-07 respectively. The same is being explained by assessee in its written submissions, which is being reproduced as under:-
"Model 1: Agreements executed between the respondent and the overseas customers Overseas customers with large and offshore centric (India based) engagements more often than not prefer to enter into agreements with the delivery arm of the ITC Infotech Group and accordingly enter into service contracts with the respondent. In such cases, the respondent retains 75% of the revenue and pays 25% of the revenue to 12A / 12B for the marketing and administrative support services provided by them in terms of the MSA between the respondent and 12A / 12B, as the case may be.
Model 2: Agreements executed between 12A / 12B and the overseas customers Overseas customers, for smaller engagements and / or those entering into India based services for the first time, mostly prefer to enter into service contracts with 12A / 12B locally, even as the delivery mechanism for these arrangements remain identical as under the Model 1 above. In such cases, 12A / 12B raise the invoice on the customer ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 5 and the respondent raises a back to back invoice for the 75% of the revenue on 12A / 12B in terms of the MSA.
Therefore, in either of the models the subsidiaries retain 25% of the revenue towards marketing and administrative support service provided by them and the respondent continues as the critical delivery engine of the Group thereby retaining 75% of the revenue."
The assessee to demonstrate the Global Delivery Model filled copies of customer proposals or contracts and submitted following copies of relevant contracts/documents between customers and ITC Infotech Group before CIT(A):
Copy of proposal for AOL ( refer pages 699, 701, 702, 707, 708, 709, 716, 735 and 747 of the assessee Paper Book for AY 2005-06 which projects 13L's expertise and capabilities even though the agreement has by been executed by 12A with the customer) Copy of proposal for Global Desktop Services Project submitted by 12B to DHL; and ( refer Pages 787 and 788 of the assessee paper book for AY 2005-06 which projects 13L's expertise and capabilities even though the agreement has been executed by 12B with the customer) Copy of proposal and agreement entered between the respondent and Finnair Oyj.
On the basis of above documents, the assessee tried to demonstrate before lower authorities and before us also that irrespective of contractual arrangement, customer proposals, which enables or facilitates the process of winning a project are heavily focused on the operational capabilities, quality parameters, technical expertise, financial stability, project experience, risks management skills and staff strengths of the assessee and not of 12A / 12B, which act as marketing entities.
7. The assessee made summary of transfer pricing adjustments for the AY 2005-06 as under:-
Sl AEs Description of the international Amount paid / payable Amount received / No. transactions receivable 1 12A Export of Software Services 36,754,764 Account management charges 37,736,909 2 12B Export of Software Services 364,592,691 Account management charges 111,186,022 ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 6 For the AY 2006-07 as under:-
Sl AEs Description of the international Amount paid / payable Amount received / No. transactions receivable 1 12A Export of Software Services 39,636,005 Account management charges 48,846,535 2 12B Export of Software Services 363,711,764 Account management charges 104,561,028 In view of the above, the assessee stated that it has completed all requirements u/s 92D of the Act read with Rule 10D of the Income-tax Rules, 1962 (hereinafter referred to as "Rules"). It was also explained that the assessee had prepared and maintained Transfer Pricing Study for computing Arm's Length Price of its international transactions and requested that as per Transfer Pricing Study, the book value of the international transactions were to be accepted at Arm's length.
8. The TPO invoked section 92CA of the Act to assessee's international transaction for making transfer pricing adjustments. For this the TPO issued notice to the assessee for initiating Transfer Pricing proceedings for these two AYs. Before TPO, the assessee for AY 2005-06 and 2006-07 filed details. But the TPO issued show cause notice, as to why transfer pricing adjustment may not be made in respect of transactions wherein the assessee enters into a contract with the customer directly and pays Account management charges to 12A and 12B and further, why adjustment may not be made on account of difference between the contractual terms in the agreement of the assessee with 12A. The assessee submitted a detailed write up explaining the entire arrangement in place in the group and showing cause that the inter-company agreements specifically provides that the provider of the actual service shall bear full responsibility for the delivery of all 'non-administrative services' i.e. service related to development of software., it facilities, management, etc. provided to a customer and shall be fully liable to other entity for the same. Here in case of split revenue contract, party who receives 75% share shall bear the full delivery risk. Therefore in any scenario whether the contract with the customer is entered directly by the assessee or entered into by 12A or 12B, the provider of 'non-administrative services' bears full responsibility for the services ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 7 provided to the customer and absolves the other party of such risks. Hence, the payment of Account Management charges by the assessee to 12A and 12B should be treated to be at arm's length. The assessee also filed copy of the Agreement between the assessee and Conoco Philips Germany Gmbh and back to back Agreement between the assessee and 12B.
9. Similarly for AY 2006-07, the TPO undertook same exercise and assessee explained the invoicing arrangements with the AEs, the roles and responsibilities of the assessee as well as of AEs and "Global Delivery Model" followed. However, the TPO issued show cause notice as to why transfer pricing adjustment may not be made in respect of international transactions wherein the assessee enters into contract with customers directly and pays 25% revenue share as Account Management Charges to 12A or 12B. The assessee made detailed submissions of entire business arrangement in assessee's group, demonstrating sufficient explanation that as per terms of inter-company agreements between the assessee and its AEs and also the actual conduct of business between them, there is no differences in either functions performed or risks assumed by transacting parties (namely, the assessee and 12A or 12B, as the case may be) irrespective of the invoicing model due to which no transfer pricing adjustment is warranted. The assessee explained that in the course of contract negotiation and mapping the scope of work, the customer is fully aware of the underlying delivery mechanism, since the technical capabilities and financial standing of the assessee are always show caused and presented before customers. Therefore, customers based on their individual preferences and requirements, chooses to enter into contract with 12A / 12B or the assessee which does not make any essential variation in the business model pursued by the assessee as a global organisation. Invoicing is the derivative of the methodology proposed to be pursued by respective customer who awards the assignment and is a prerogative of the customer. The TPO considered the 25% revenue split in favour of 12A or 12B in case of contracts entered directly by the assessee to be excessive and allowed the payment only up to a revenue split of 13% in case of 12A and 15% in case of 12B. The assessee for both the AYs, submitted voluminous evidences to bring out the facts of the case. For AY 2005-06, the same were submitted before the CIT (A), subject to remand proceedings. For AY 2006-07, such submissions were made before the TPO himself, but he failed to give due cognizance to such voluminous submissions and passed the order in sheer disregard of the same, proposing an ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 8 adjustment in line with AY 2005-06. Finally the TPO made adjustment to Arm's Length Price of the 'Account Management charges' paid by the assessee to its AEs and recomputed as follows:
AY 2005-06 Sl AEs Arm's length Price computedArm's by length Price computed byAdjustment the made No. the respondent Ld. TPO 1 12A 37,736,909 19,623,192 18,113,717 2 12B 111,186,022 66,711,613 44,474,408 AY 2006-07 Sl AEs Arm's length Price computedArm's by length Price computed byAdjustment the made No. the respondent Ld. TPO 1 12A 48,846,535 25,400,198 23,446,337 2 12B 104,561,028 62,736,616 41,824,412
10. Aggrieved against assessment based on transfer pricing adjustments, the assessee filed appeals for both AYs before CIT (A). After considering submissions made by the assessee, CIT (A) found merit in the facts of the assessee. The CIT(A) considered economic substance underlying the assessee's global business model including sharing of the functions and risks and deleted adjustments made by AO based on the order of the TPO. He observed as under:-
"I have considered the transfer pricing documentation maintained by the appellant, the appellant's submission and the rebuttal of the Remand Report by the Appellant and the observations and the Remand Report of the TPO.
After perusing the above, I hold that:
The appellant, in compliance with the law, prepared and maintained the TP Report for computing the arm's length price of its international transactions. As embodied in the TP Report, the appellant has adopted the Cost Plus Method as the most appropriate method to establish the arm's length price of the relevant transactions undertaken by the appellant with 12A and 12B while selecting 12A and 12B as the 'tested party'. From the facts and documents presented before me, I find that the appellant's business arrangement with its foreign subsidiaries can be categorised into the following two revenue sharing models;
Model 1- In this model, the agreement are executed between the appellant and the overseas customers. In cases where the appellant retains 75 of the revenue and pays 25% of the revenue to its subsidiaries 12A / 12B for the marketing and administrative support services provided by them in terms of the Master Service Agreement entered into between the appellant and the AE's namely 12A/12B.
ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 9 Model 2- In this model, the agreements are executed between 12A / 12B raise the invoice on the customer and the appellant raised a back-to-back invoice for the 75% of the revenue on 12/12B in terms of the Master Service Agreement.
Evidently 12A or 12B retains 25% of the revenue towards marketing and administrative support services provided by them and the appellant continuous as the delivery engine of the group and retains 75% of the revenue. In both the above two models the appellant undertakes and assumes significant and analogous functions and risks and consequently undertakes full responsibility for the delivery of all IT development services to a customer. I agree with the appellant's submissions, which has been reproduced in detail above, that under both the above scenarios, the functional and risk profiles of 12A and 12B remain the same. Incidentally, 12A and 12B do not have the technical competencies and financial capabilities to bear any loss arising in the form of bad debt or delivery failure; and would need to revert back to the appellant in case any such events occur. It is a fundamental principle of transfer pricing that risks should be allocated to the entity, which has greater control over the same and also, who has the financial capabilities to bear the same. In the instant case, I find that 12A and 12B do not have technical competencies or financial capacity to manage or bear risks arising out of bad debts or delivery failure resulting in non performance of the contract. The entire capabilities and financial strength in this regard lie with the Appellant in India and thus, as per the very conduct of the parties while doing business, it can be said that the Appellant bars the full risk of such maters under either of the two models, as enunciated above. The TPO observed that the foreign customers, while entering into the contracts with 12A or 12B would be in a position to hold such entities responsible for failure of delivery / non- performance of the contract and thu9s in cases of such direct dealings, 12A and 12B bear greater risk as compared to the other model where the customers enter into contracts directly with the appellant. In my view, this logic is flawed. The determinant factor is not whether the customers can hold 12A or 12B responsible for failure of performance, but whether, as per the functional, asset and risk profiles of the three entities, namely the appellant, 12A and 12B, if 123A and 12B do not have the necessary confidence and functional strength to bear such risks, and thereby the risk should be awarded to such party under an arm's length dealing. In my view, base upon the documents submitted by the appellant and the arguments put forward before me, under either of the two situations, the functional, asset and risk profiles of 12A and 12B remain the same and the major risks relatable to bad debt and delivery failure / non- performance, always remain with the appellant, irrespective of the two business models. I find that the TPO had in-principle accepted the remuneration model of 25% revenue sharing in case where the customers enter into contract with 2A and 12B. I also find that the remuneration model of 25% revenue sharing has been substantiated and justified by the appellant to be at arm's length, by carrying out proper comparability analysis, as part of the documentation submitted with the TPO. Since, in my view, based upon the reasoning given above, the functional and risk profile of 12A and 12B remain the same under either of the two models, namely even where the customers enter into the contracts directly with the appellant, the same remuneration model of 25% revenue sharing should also apply in such business scenario. I cannot agree with the TPO's arbitrary fixation of the remuneration model of 13% / 15% revenu9e sharing in the late5r scenario, namely whether the customers enter into contracts directly with the appellant, since the same appears to be without any basis whatsoever. Further, as discussed above, the logic of the TPO in coming to the conclusion of difference in functional and risk profiles under the two scenarios, appear to be erroneous. I also find ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 10 support from the decisions of the Hon'ble Mumbai Tribunal rendered in the case of DCIT 9(2) Vs M/s Indo American Jewellery Ltd (ITA No.6194/Mum/2008) and ITO 10(3)(4) Vs M/s. Zyds Atlanta Healthcare Pvt. Ltd. (ITA No.3311 & 3312/Mum/2008), which have been relied upon by the appellant that of the appellant enjoys tax holiday or exemption with respect to its export profits, then any presumption of shifting of profits by the ape to overseas associated entities through mechanics of transfer pricing, would prima-facie stand defeated, since the moot question remains why would an assessee shift profits to a tax paying jurisdiction, when, by retaining the profits in India, he would have enjoyed full tax exemption on the same.
In view of the above findings, I delete the addition of ₹ 6,25,88,125 and allow this ground of the Appellant"
Aggrieved, revenue came in second appeal before tribunal.
11. Ld. counsel for the assessee before us argued that the TPO was of the view that where the customer is entering into contract directly with the assessee, risk of discharging contract and other legal obligations are on it as compared to the scenario where customer is entering into contract with subsidiaries, wherein risk lies with subsidiaries. Hence, in the first scenario, where subsidiaries do not assume any risk at all, they are retaining 25% of the sales proceeds similar to what they are entitled to do in case where they bear the entire risk (in case of contracts directly with customer). He also highlighted that in clause 4A(iii) of the Master Agreement between the respondent and 12A, dealing with the provision of administrative services to the respondent by 12A, mentions that:
"If 13L (the respondent) subcontracts its obligation in accordance with these clause, the parties agree that the provisions of clause 5(iii) to (v) inclusive shall not apply and that a fee equal to 25% of the revenue derived from the customer contact shall be paid by 13L (the respondent) to IINFOTECH US."
TPO contended that it is evident that if 12A subcontracts its obligations to the assessee, 12A will have to discharge all the administrative functions including those mentioned in clause 5(iii) to 5 (v), however if the assessee subcontracts its obligations to 12A, the above mentioned functions would not be discharged by 12A. However since in both the scenario, 12A is entitled to 25% of the sales proceeds, he believed that this prima-facie is not an arm's length transaction. While re-computing the Account Management charges paid by the assessee to 12A and 12B, the TPO observed that "What an entrepreneur primarily earns is the reward for the risk that he takes while entering into a business venture. The actual administrative conduct of the business may be routine and repetitive in nature. The higher the ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 11 risk, the more should be the reward expected. In the above mentioned scenario, the foreign clients, despite having the foreign subsidiaries in their own countries with whom they could have easily entered into the contracts and could have monitored and legally enforced the contract in their own countries, have chosen to bypass these subsidiaries and have selected to deal directly with ITC Infotech India Ltd. This obviously and patently underlines the mindset of the client to reduce their risk perception by entering into contract with ITC Infotech India Ltd. ITC Infotech India Ltd., will suffer a greater loss of reputation in case of the contract not being executed properly. Hence, the risks undertaken by ITC Infotech India Ltd. Should occupy a larger portion in the rate of sharing of revenue and hence a higher rate of 10% has been attributed towards the risk undertaken by ITC Infotech India Ltd., Hence, an adjustment of 10% is being made to the 25% revenue shared by the subsidiaries."
Accordingly, 15% revenue sharing was adopted by the TPO as against 25% rate provided in the Master Agreement.
Further, payment of account management charges by the assessee to I2A, TPO noted that, "When an USA client enters into a contract directly with ITC Infotech India Ltd and ITC Infotec India Ltd, subcontracts the administrative function to the USA subsidiary, the USA subsidiary is excluded from discharging the functions mentioned in Clause 5(ii) to (v) of the Master Agreement. Thus, under these circumstances ITC Infotech, USA should be entitled to a lesser share of the revenue than what it is entitled to when the client enters into an agreement with ITC Infotech, USA directly and ITC Infotech, USA has to discharge all the administrative functions including those mentioned in Clause 5 (iii) to (v) of the Master Agreement. Thus further adjustment is required in the share of revenue earned in case of ITC Infotech, USA when the client enters into an agreement directly with ITC Infotech India Ltd."
Accordingly, 2% ad hoc adjustment was made and thereby 13% revenue sharing rate was adopted by the TPO rather than 25% rate as provided in the Master Agreement. Based on the above, transfer pricing adjustment was computed by the TPO as follows:
Adjustment in arm's length price - 12B Account management charges paid during the year by the Rs.11,186,022 ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 12 respondent Less: Arm's length price as discussed above [Rs.11,11,86,022 xRs. 66,711,613 15/25] Adjustment to the ALP Rs. 44,474,408 Adjustment in arm's length price - 12A Account management charges paid during the year by the Rs. 37,736,909 respondent Less: Arm's length price as discussed above [Rs. 3,77,36,909 x Rs. 66,711,613 13/25] Adjustment to the ALP Rs. 18,113,717 Similarly, the transfer pricing adjustments made by the TPO in AY 2006-07 were as follows:
Adjustment in arm's length price - 12B Account management charges paid during the year by the Rs. 10,45,61,028 respondent Less: Arm's length price as discussed above [Rs. 10,45,61,028 xRs. 6,27,36,616 15/25] Adjustment to the ALP Rs. 4,18,24,412 Adjustment in arm's length price - 12A Account management charges paid during the year by the Rs. 4,88,46,535 respondent Less: Arm's length price as discussed above [Rs. 4,88,46,535 x Rs. 2,54,00,198 13/25] Adjustment to the ALP Rs. 2,34,46,337 But, ld. counsel for the assessee argued that the TPO in both the AYs has accepted revenue split of 25:75 to be at arm's length based on the functions performed by transacting parties. Thus, if under both the business models the assessee and its subsidiaries perform the same functions and assume same risk then no adjustment is warranted to the arm's length price of international transactions entered into by the assessee merely based on the contention that the customer contracts are entered into by different parties. It was further stated that the assessee provided additional documents that were demanded by CIT (A), which were not asked for by the TPO at the time of assessment proceeding. The assessee submitted copies of relevant contracts/documents between customers and assessee's group to establish methodologies of the different invoicing arrangements adopted by overseas clients and 12A and 12B ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 13 respectively and it would not make any difference in the risk reward profiles of these entities. Various documents related to "AOL" contract where the customer has entered into contract with 12B and 12A has performed marketing and account management functions and earned 25% of the revenue, while the assessee has performed delivery functions and has earned 75% of the revenue. Various documents related to "DHL" contract where the customer has entered into a contract with 12A and 12B has performed marketing and account management function, while the assessee has performed delivery functions where the revenue sharing arrangement between 12B and the assessee remains exactly identical as in the above case. Various documents related to "Finnair" contract where the customer has entered into contract with the assessee and assessee has performed delivery functions and has earned 75% of the revenue, while 12B has performed the marketing and account management services and has earned 25% of the revenue.
12. According to ld. counsel, the CIT(A) referred documents to the TPO and he vide remand report No. DIT(IT)/Kol/Misc/10-11/24 dated 2nd June 2010 filed before the CIT (A), held that in cases where foreign subsidiaries enter into contact with customers, risk for execution of contract lied solely with foreign subsidiaries and that contention of the assessee that risk lies with it was held to be unsustainable by TPO.
Similarly for AY 2006-07 also the assessee filed detailed submission summarising international transactions which were subject to adjustments along with facts and circumstances. After considering submissions and arguments put forth by the assessee for both the AYs, the CIT (A) found merit in the facts and granted relief deleting the entire transfer pricing adjustment for both the AYs.
13. We noted from factual aspects of the case that the TPO perceived that functional and risk profile of the assessee and its AEs are different in both the business models wherein the assessee assumes larger share of risks when contracts are entered by it with customers (Business Model-I) as compared to arrangements wherein the AEs executes the contract with customer (Business Model-II). The two business models are optically different (in terms of contractual party), but the functional and risk profile of both the assessee and its AEs remain ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 14 the same in both the models, which is evident not only from the terms of the MSA but also from the conduct of the parties. The assessee has explained the business model followed by it along with its functional and risk profile. The assessee explained the "global Delivery Model"
as adopted and forming the very basis of two alternative inter-company invoicing models. The business model followed by the assessee and 12A/12B is summarised below:-
Model I - Where the customer directly enters into the contract with the respondent; and Model II - Where the customer directly enters into the contract with 12A/12B The assessee explained the economic substance underlying the two arrangements, the roles and responsibilities and the functional profile of the assessee as well as that of its AEs 12A/12B. Further, it explained that inter-company invoicing agreements and contractual terms entered with the AEs. Under both the business model, the basic functions of the subsidiaries, with regard to the administrative functions i.e. account management, are same. On the other hand, assessee is performing non-administrative functions under both the business models and thus entire risks with regard to non-administrative services are being borne by the assessee irrespective of the business model. Furthermore, it was also explained that customers enter into contract with either assessee or 12A/12B with the basic understanding that the activities/services in connection with development of the assignment/project would be essentially driven by assessee in adherence with various commercial and technical qualification parameters/norms specified by the customer namely share capital, average revenue over a period of time, brand value, reputation in the market, track record of successful project, vast and experienced resource pool with expertise in various areas of work, etc. Hence, the essential factor for awarding a service contract would always be technical and commercial expertise and experience of the assessee in handling such similar projects. The local presence of the AEs or it stand-alone financial or technical capabilities hardly influence the decision of the customer to sign the agreement with the AEs. The assessee stated that the possibility of a customer raising any claim for deficiency in administrative services are very remote, as they are rendered to the assessee as an internal arrangement and the customers are not affected by it. Only possibility of any customer raising a claim would be in respect of non-administrative services which are exclusively provided by ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 15 the assessee irrespective of the business model. It was also emphasised that it is the assessee, which has adequate capital and technical expertise to bear the risks arising from deficiency in services, which neither 12A nor 12B possess. Thus even if a customer raises any claim on 12A/12B, such risk would be eventually passed on to the assessee.
14. There is contractual relationship among the assessee, its subsidiaries and third parties. The subsidiaries, based on agreement entered into with the assessee, engage in marketing of the IT service capabilities of the assessee in their respective countries and try to win contract for providing IT services. Once a customer is identified, the subsidiaries in coordination with the assessee try to win the customer contract. As it has been explained through the sample customer proposals, the customer is made aware of the assessee's technical expertise, experience, resource pool etc. from initial stages of the proposal/bidding stage. Once the customer is won, the subsidiaries download the non-administrative services to the assessee. There may be some customers who may not be at all willing to enter into a contract with the subsidiaries as the subsidiaries on a stand-alone basis may not be fulfilling the conditions set by the customers for awarding the contract for provision of IT services. However, these customers may be willing to enter into a contract with the assessee as it has the requisite man power for providing IT services, vast and experienced resources pool with expertise in various areas of work, adequate share capital for bearing the risk arising out of the contract, average revenue over a period of time, brand value, reputation in the market, track record of successful projects, etc. In such cases, the contract is entered into between the customer and the assessee but the functions and risks undertaken by both the assessee and its subsidiaries remain the same as they are when the customers enter into the contract with the subsidiaries. Ld. counsel explained the concept of 'conduct of the parties' and risks associated with it. He referred to para 5.3.2.22 and 5.3.2.23 of the United Nations Practical Pricing Manual on Transfer Pricing for Developing Countries ('Practice Manual') wherein, allocation of risk and conduct of parties is explained that:-
'It is not only necessary to identify the risks but also to identify who bears such risks. The allocation of risks is usually based on the contractual terms between the parties. However, contacts between associated enterprises may not specify the allocation of all the risks.
ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 16 Even where a written contract is in place, an analysis of the conduct of the parties is critical in order to determine whether the actual allocation of risk conforms to the contractual risk allocation' 'When analysing the economic substance of a transaction, it is necessary to examine whether the conduct of the associated enterprises over time has been consistent with the purported allocation of risk and whether changes in the pattern of behaviour have been matched by changes in the contractual arrangements (emphasis added) Furthermore, in relation to contractual relationship and conduct of the contracting parties, para 5.3.2.30 states that:
The conduct of the contracting parties is generally a result of the terms of the contract between them. The contractual relationship thu9s warrants careful analysis when computing the transfer price. Other than a written contract, the terms of the transactions may be found in correspondence and communications between the parties involved. In cases where the terms of the arrangement between the two parties are not explicitly defined, the contractual terms have to be deduced from their economic relationship and conduct.
(emphasis added) It is also pertinent to mention at this juncture that the concept of business risk in transfer pricing context has been discussed at length in the recent amendments to the OECD Transfer Pricing Guidelines 2010 (hereinafter referred to as "OECD Guidelines") under the new Chapter IX (Transfer Pricing Aspects of Business Restructuring). As per this new guidance, para 9.10 provides that:
"Risks are of critical importance in the context of business restructurings. An examination of the allocation of risks between associated enterprises is an essential part of the functional analysis. Usually, in the open market, the assumption of increased risk would also be compensated by an increase in the expected return, although the actual return may or may not increase depending on the degree to which the risks are actually realized."
Under para 9.11 and 9.12:
"... .. the examination of risks in an Article 9 context starts from an examination of the contractual terms between the parties, as those generally define how risks are to be divided between the parties. Contractual arrangements are the starting point for determining which party to a transaction bears the risk associated with it ... .."
... a tax administration is entitled to challenge the purported contractual allocation of risk between associated enterprises if it is not consistence with the economic substance of the transaction . Therefore, in examining the risk allocation between associated ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 17 enterprises and its transfer pricing consequences, it is important to review not only the contractual terms but also the following additional questions:
· Whether the conduct of the associated enterprises conforms to the contractual allocation of risks, · Whether the allocation of risks in the controlled transaction is arm's length, and · What the consequences of the risk allocation are."
Specific attention was drawn to the concept of 'risk allocation' and 'control', on which para 9.22 and 9.23 of the OECD Guidelines state that:
"In the absence of comparables evidencing the consistency with the arm's length principle of the risk allocation in a controlled transaction, the examination of which party has greater control over the risk can be a relevant factor to assist in the determination of whether a similar risk allocation would have been agreed between independent parties in comparable circumstances. In such situations, if risks are allocated to the party to the controlled transaction that has relatively less control over them, the tax administration may decide to challenge the arm's length nature of such risk allocation.
..."control" should be understood as the capacity to make decisions to take on the risk (decision to put the capital at 5risk)) and decisions on whether and how to manage the risk, internally or using an external provider. This would require the company to have people - employees or directors - who have the authority to, and effectively do, perform these control functions. Thus, when one party bears a risk, the fact that it hires another party to administer and monitor the risk on a day-to-day basis is not sufficient to transfer the risk to that other party."
Further, the OECD Guidelines have also discussed on the issue of "risk allocation" and "financial capacity" in para 9.29 9.30 as follows:
"Another relevant, although not determinative factor that can assist in the determination of whether a risk allocation in a controlled transaction is one which would have been agreed between independent parties in comparable circumstances is whether the risk- barer has, at the time when risk is allocated to it, the financial capacity to assume (i.e to take on) the risk.
Where risk is contractually assigned to a party (hereafter 'the transferee) that does not have, at the time when the contract is entered into, the financial capacity to assume it, e.g. because it is anticipated that it will not have the capacity to bear the consequences of the risk should it materialise and that it also does not put in place a mechanism to cover it, doubts may arise as to whether the risk would be assigned to this party at arm's length. In effect, in such a situation, the risk may have to be effectively borne by the transferor, the parent company, creditors, or another party, depending on the facts and circumstances of the case, irrespective of the contractual terms that purportedly assigned it to the transferee."
Based on the above OECD Guidelines and Practice Manuals, we are of the view that the conduct of the assessee and its AEs should be given due cognizance which in the assessee's ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 18 case is same in both the business models. The assessee has also explained from the table, that the functions performed and the risks assumed by the assessee and its AEs under both the business models are the same i.e. the assessee undertakes the core delivery functions and assumes the service liability risks while the AEs are only engaged in marketing and administrative functions.
Further, the sample proposal documents submitted by the assessee also vindicates that the prospective customers are fully aware of assessee's technical capabilities and expertise while awarding a contract and even if the actual contract is executed by the AEs, the customer would presumably not tend to believe that the offshore IT/software development services under Global Delivery Model is being rendered by the AEs and not the assessee. Hence, the execution of the agreement directly by the assessee or by the AE would not create any substantial difference in the sharing of functions or risks between the parties or in turn, would not change the functional characteristic of the parties.
15. Now before us Ld. counsel explained possible claim by customer for provision of services by the assessee and 12A/12B that · Claim for any deficiency in administrative service -
That the possibility of a customer raising any claim for any deficiency in administrative services seems to be very remote as the customer is not impacted by the services which are in the nature of travel arrangements and liasing between the customer and the respondent. It is the respondent who would be impacted for any deficiency in the services provided by the subsidiaries. The only area of any probable dispute and consequential claims is with regard to non-administrative services which are being provided by the respondent u9nde both the business models.
· Claim for any deficiency in non-administrative services -
The Ld. TPO, vide his order, has acknowledged the fact that the MSA very clearly envisage that the subsidiaries would sub-contract to the respondent the non-administrative services and the provider of these non-administrative services, i.e., the respondent would be fully liable to the user, i.e., customer for the same.
He further submitted that it has the adequate capital and the technical expertise to bear the risk that may arise for any deficiency in the services provided to the customers. The ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 19 subsidiaries do not have adequate capital or technical expertise to bear such a risk. Thus, in our view, under the Business Model 2, as per terms of the MSA, in case a Customer raises any claim for non-performance of the non-administrative services, the subsidiaries would eventually pass on such risk to the assessee and the assessee has to bear such risk. The customers enter into contract with either the assessee or the subsidiaries for providing software development services. The contracts entered with customers also mention the expected standard of services to be provided for software development work. It is the internal arrangement between the assessee and the subsidiaries where the marketing and the administrative functions are performed by the subsidiaries under both the business model. The subsidiaries provide the marketing and the administrative services to the assessee and not to the clients. Thus, in both the business model the risk profiles of the subsidiaries remain the same. Further, in course of the contract negotiation and mapping of the scope of work, the customer is fully aware of the underlying delivery mechanism, since technical capabilities of the assessee are always showcased and presented before the customer. Therefore the customer based on their individual preferences and driven by the considerations, which are exclusively their own, chooses to enter into contract with 12A / 12B or the assessee, which does not make any essential variation in the business model as a global organisation. Invoicing is the derivative of the methodology proposed to be pursued by the respective client who awards the assignment. The prospective customer is also fully aware of the financial standing of 12A / 12B vis-a-vis the ITC Infotech Group even while entering into service contract with 12A / 12B in view of the fact that every service proposal specifically highlight the technical strength and the financial strength of the assessee which plays its pivotal role before the clients while entering into a contract with 12A / 12B. Hence, the presumption of the TPO that the overseas customers' decision to enter into contracts directly with 12A or 12B are essentially governed by the standalone financial or technical strengths of these entities devoid of the backup of the assessee's financial / technical strengths, is inappropriate and without any basis.
16. Further, in relation to quantification of Risk adjustment, we are of the view that the exercise of risk adjustment is not a simple exercise. A lot of research has been carried out in this field of economics over the years, as a result of which various theories have evolved, that have been applied across businesses to quantify the inherent business risks. However, the ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 20 subject of risk evaluation and quantification has continued to be an area of extensive study and research.
The assessee vide submission dated 11th October, 2009 briefly discussed one such concept in the area of risk management i.e., towards risk evaluation and quantification. In case of the assessee, there is an inherent transfer of risk by 12A / 12B to the assessee vide the MSA in relation to cases where the customer contacts directly with these. AEs and there are financial claims relating to the quality of deliverables. Such a transfer of risk through contractual arrangement is a common risk management practice in commercial world and should be duly recognized. The TPO made adjustment by determining a different revenue split [15% or 13% as the case may be] from the one followed by the respondent and 12A / 12B. Such an adjustment made by the TPO was without any basis or analysis. In relation to difference in clauses in the MSA between the assessee and 12A as referred to by the TPO for making an ad-hoc adjustment, the assessee further drew our attention towards Clauses 4A (iii) and clause 4B (ii) of the MSA which provides for the same effect in relation to exclusion of certain administrative services to be performed, Clause 4B (ii) provides that:
"if INFOTECH US subcontracts its obligation in accordance with this clause 4(B), the parties agree that the provisions of clause 5(iii) to (v) inclusive shall not apply and that a fee equal to 75% of the revenue derived under the applicable customer contract from non-administrative services provided by the respondent's employees shall be paid by INFOTECH US i.e '12A' to the respondent."
Further, the assessee also calculated the effect of adjustment on profitability of ITC Infotech Group taking into consideration the risk adjustment envisaged by TPO for the AY 2006-07 and submitted that both 12A and 12B would make losses at net level if the risk adjusted pricing model, as proposed by the TPO were put in actual practice. Thus the risk adjusted business model as proposed by the TPO would result in an absurd situation from 12A / 12B's perspectives defeating the concept of stable positive return for a low risk tested party. In the light of the above, we are of the view taking into cognizance the business model of the assessee along with the functions undertaken and risks assumed by the assessee and its subsidiaries, the facts and written submission made during the course of the proceedings for both the AYs 2005-06 & 2006-07, that the TPO totally erred in making transfer pricing adjustments in the case of assessee in both the AYs. In view of facts and circumstances, we are of the view that the TPO just on the basis of conjunctures and surmises made this transfer ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 21 pricing adjustments. Hence, we dismiss this common issue of revenue's appeals in both the AYs.
17. The next common issue in these two appeals of revenue is against the order of CIT(A) deleting the disallowance of software expenses. For this following ground no. 4 is raised in AY 2005-06 reads as under:-
"4. That on the facts & circumstances of the case the Ld. CIT(A) erred in deleting the addition of Rs.6897876/- made on purchase of software in the head "operating & manufacturing expenses" wrongly interpreting it as an expense revenue in nature whereas the expenditure is of capital nature."
18. We have heard rival contentions and gone through facts and circumstances of the case. We find that the AO made disallowance of Software expenses in AYs 2005-06 & 2006-07 amounting to Rs.68,97,876/- & 9,67,408/- respectively. But CIT(A) deleted by holding the software expenses to have been incurred for the purposes of business not resulting in any enduring benefit. Aggrieved, now revenue is in second appeal before tribunal for both AYs.
19. We find that during the AYs 2005-06 & 2006-07, the assessee incurred expenditure in connection with the purchase of software. The assessee is engaged in the business of software development and this software was acquired by it in connection with client projects. The software acquired was application software. During assessment proceedings also the assessee asked as to why such software expenses should not be treated as capital expenditure and it explained to AO in detail about the software acquired and the business necessity of such software. It was explained that the software acquired were application software which were being used by the assessee for its business of developing software for it clients and did not result in any enduring benefit. Even now before us also it was explained that the expenditure on purchase of software represented application software exclusively used for the purpose of the business and hence these were treated as revenue expenses in line with the principles enunciated in section 37(1) of the Act. These application software, have got a limited useful life and are used as tools of business like any other component or consumable item used for the purpose of earning revenue though application in the process of customer servicing and does not result in any enduring benefit. It is also important to note that it is neither a stand- along profit generating apparatus nor an income driving structure so as to classify the ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd 22 expenditure incurred towards the software as one on capital account. The application software, being the subject matter of appeal, assist the already set-up business vide enhancing its efficiency and hence can be reliably related to being on revenue account. List of software purchased are enclosed in assessee's paper book for AYs 2005-06 & AY 2006-07. On perusal of the same, we find that the parties from whom the software was acquired were Interwoven, Mercury Interactive (Singapore) Pvt. Limited, Sonata Information Technology and Tata Consultancy Services. All these companies specialize in application software which helps in increasing the efficiency of client deliverable. The details of payments made to M/s Interwoven clears that these are towards payment for renewal of software which the assessee was using for client deliverables. In view of these facts, we are of the view that software expenses are revenue in nature and allowable u/s 37 of the Act. We dismiss this common issue of revenue's appeals.
20. In the result, both appeals of the revenue are dismissed.
यह आदेश खुले यायालय म सुनाया गया है तार ख
Order pronounced in the open court on 09/01/2015
Sd/- Sd/-
[शामीम याहया , लेखा सद य] [महावीर संह, यायीक सद य]
Shamim Yahya, Accountant Member Mahavir Singh, Judicial Member
(तार ख) Dated:09th January, 2015
*PP व र ठ निज स चव /Sr.P.S.
आदेश क त ल प अ े षतः- Copy of the order forwarded to:
1. अपीलाथ /Appellant- DCIT,Cir-, P-7 Chowringhee Sq, Kol
2 यथ / Respondent : ITC Infotech India Ltd 37 J.L.Nehru Rd. Kol-71
3. आयकर क मशनर/The CIT,
4. आयकर क मशनर (अपील)/The CIT(A), Kolkata
5. वभा गय तनीधी/DR, Kolkata Benches, Kolkata
स या पत त/True Copy, आदेशानुसार/ By order, सहायक पंजीकार/Asstt. Registrar
ITA No. 2222 & 2223/Kol/10 ITC Infotech India .Ltd
23