2020 (8) TMI 855 - AT - Income Tax

TP Addition - international transaction of software development services rendered by the Appellant to its parent company - Comparable selection - Functional dissimilarity - HELD THAT - Assessee as engaged in providing software development and IT enabled services or say engaged in providing software services , companies as functionally dissimilar with that of assessee need to be deselected from final list. DRP has upheld the filter of the rejection of the companies with service income less than 75%. E-Infochips Ltd. - Details of margin on hardware sales is not available and if the margin on hardware is too high as compared to software services, the company may not be suitable for comparison. Due to lack of sufficient information in respect of the company available in the public domain, in the interest of substantial justice, we feel appropriate to restore the issue of comparison to the Ld AO/TPO with the direction to the TPO to obtain such information in the form of relevant schedules of the Profit Loss Account of the said entity as well as the segmental details of the hardware division, if any, directly from the said entity and then decide the issue of comparability. We, therefore, set aside the finding of learned TPO for including the company into set of comparables as well as the direction given by the DRP on this issue and restore the matter to the file of the Assessing Officer/TPO for deciding the same afresh in the light of the observations already made by us, after giving the assessee a proper and sufficient opportunity of being heard. E-Zest Solutions Limited - As far as issue of functional dissimilarity on the ground of conceptualization of the software is concerned, we do not agree with the argument of the learned Counsel of the assessee. although the company is functionally similar to the assessee but in view of the figure of increase in the stock gives rise to the possibility of trading segment. As complete information is not available in public domain, in our opinion, the Learned TPO can collect the relevant information from the company using the authority under section 133(6) of the Act and if he finds that trading segment exist and no separate results are available for the software development segment, then he shall exclude the company from the set of the comparables. Accordingly, we restore the issue of the comparability of the company to the file of the Learned AO/TPO for deciding afresh after providing adequate opportunity of being heard to the assessee. Infosys Ltd. - Tribunal has rejected the company mainly on the ground of giant company vis- -vis the assessee being a captive service provide. Since this ground of the rejection is valid in the year under consideration also we direct the Learned AO/TPO to exclude this company from the final set of the comparables. Larsen and Toubro Infotech Ltd. - As revenue has been shown from software development services and products and there is no separate segment of the software development services available in the annual report of the company. In such a huge turnover, the composition of revenue from the software development services and from sale of the software products is not separately available in the annual report. In such circumstances, the company cannot be termed as functionally similar at entity level with the assessee, who was engaged in providing software services to its associated enterprises. In view of the functional dissimilarity, we direct the Learned AO/TPO to exclude this company from the final set of the comparables. Persistent Systems Solutions Ltd - As revenue has been shown from the software services only and no revenue has been shown from sale of the products or from royalty etc. Merely mention of the method of the recognition of the revenue in the notes to the account, cannot indicate revenue has been earned from sale of the products or from the royalty. No other information has been pointed out by the learned Counsel to support his contention that the company is engaged in sale of the products. No such information in respect of sale of products or income from royalty is available in the public domain, therefore in the interest of the justice, we feel it appropriate to restore this matter to the Learned AO/TPO with the direction to gather information using authority under section 133(6) of the Act and if he finds presence of substantial income from sale of the products or royalty and income from software development services cannot be segmented, then the company shall be excluded from the set of the comparable. The assessee shall be afforded adequate opportunity of being heard. Persistent Systems Ltd. - As revenue from sale of software services and product has been shown that ₹ 6,101.27 million. There is no separate bifurcation of the revenue from the software services and therefore in absence of segmental data of software services, the company cannot be included as a comparable at entity level. Accordingly, on the ground of the functional dissimilarity of the entity level, we direct the Learned AO/TPO to exclude the company from the final set of the comparables. Wipro Technology Services Ltd. company is directed to be excluded from the set of the final comparables. Zylog Systems Ltd. - As the Revenue as shown from Software Development services and the products and no separate revenue or segmental result for software development services have been reported in the annual report. In absence of any separate segmental result of software development services available in public domain, we reject the company as comparable on functional dissimilarity at entity level. Accordingly, we direct the Ld. AO/TPO to exclude this company from the set of the final comparables.

Summary

Issues Involved:
1. Assessment of total income and transfer pricing addition.
2. Adjustment to the arm's length price and eligibility for Section 10A deduction.
3. Reference to the Transfer Pricing Officer (TPO) without recording reasons.
4. Confirmation of TPO’s addition without appreciating the appellant’s computation method.
5. Rejection of the appellant’s Transfer Pricing Study.
6. Application of various filters by the TPO.
7. Rejection of comparable companies selected by the appellant.
8. Inclusion of non-functionally comparable companies.
9. Inclusion of companies with fluctuating margins.
10. Inclusion of companies with controlled transactions.
11. Treatment of foreign exchange gain/loss and hedging costs.
12. Denial of risk adjustment.
13. Initiation of penalty proceedings under Section 271(l)(c).
14. Charging of interest under Sections 234B and 234D.

Detailed Analysis:

1. Assessment of Total Income and Transfer Pricing Addition:
The AO assessed the total income at ?22,20,27,590 against the returned income of ?1,90,27,743, making a transfer pricing addition of ?20,29,99,837 for software development services rendered to the parent company.

2. Adjustment to Arm's Length Price and Section 10A Deduction:
The TPO and DRP proposed an adjustment without considering the appellant’s eligibility for Section 10A deduction, which negates any motive to shift profits outside India.

3. Reference to TPO Without Recording Reasons:
The AO made a reference to the TPO without recording the necessary reasons, which the appellant argued was essential for such a reference.

4. Confirmation of TPO’s Addition:
The AO and DRP confirmed the TPO’s addition without appreciating the appellant’s computation of the arm's length price using the transactional net margin method (TNMM) and maintaining required documentation.

5. Rejection of Transfer Pricing Study:
The AO and DRP implicitly rejected the appellant’s Transfer Pricing Study and conducted a fresh benchmarking analysis based on conjectures and surmises.

6. Application of Various Filters by TPO:
The AO and DRP erred in confirming the TPO’s application of filters such as:
- Use of only current year data.
- Rejecting companies with turnover below ?5 crores without an upper filter.
- Rejecting companies with less than 75% revenue from services.
- Rejecting companies with export sales less than 75% of total sales.
- Rejecting companies with persistent losses.
- Rejecting companies with related party transactions exceeding 25%.
- Rejecting companies with employee costs less than 25% of total operating costs.
- Rejecting companies with different financial years.

7. Rejection of Comparable Companies:
The AO and DRP erred in rejecting comparable companies selected by the appellant without providing sufficient reasoning.

8. Inclusion of Non-Functionally Comparable Companies:
The AO and DRP included companies that were not functionally comparable, such as:
- E-Infochips Ltd.: The company was involved in hardware sales and did not meet the 75% service revenue filter.
- E-Zest Solutions Ltd.: The company was involved in product engineering and had stock transactions.
- Infosys Ltd.: The company was a giant with diversified services, significant intangibles, and brand value, making it incomparable to the appellant.
- Larsen & Toubro Infotech Ltd.: The company had no separate segment for software development services.
- Persistent Systems Ltd.: The company was involved in product development and had significant R&D expenses.
- Wipro Technology Services Ltd.: The company had controlled transactions with Citigroup.
- Zylog Systems Ltd.: The company had mixed revenue from software development and products without segmental reporting.

9. Inclusion of Companies with Fluctuating Margins:
The AO and DRP included E-Infochips Bangalore Ltd., which had fluctuating margins, making it unsuitable for comparison.

10. Inclusion of Companies with Controlled Transactions:
The AO and DRP included Wipro Technology Services Ltd., which had controlled transactions with Citigroup, making it a tainted comparable.

11. Treatment of Foreign Exchange Gain/Loss:
The DRP erred in treating foreign exchange gain/loss and hedging costs/premium as non-operating income/expense.

12. Denial of Risk Adjustment:
The AO and DRP denied the risk adjustment claimed by the appellant under Rule 10B(1)(e) read with Rule 10B(3).

13. Initiation of Penalty Proceedings:
The DRP erred in mechanically initiating penalty proceedings under Section 271(l)(c) by holding that the penalty is consequential.

14. Charging of Interest:
The AO erred in charging interest under Sections 234B and 234D and computing interest under Section 234B in violation of the provisions of the Act.

Conclusion:
The appeal was partly allowed for statistical purposes, with directions to the AO/TPO to re-evaluate the inclusion/exclusion of comparable companies and other issues based on the detailed observations and after providing the appellant with a proper opportunity of being heard.