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2008 (6) TMI 299 - AT - Income Tax100 per cent EOU unit - transfer pricing - Addition on Adjustment in the arm's length price (ALP) u/s 92CA(3) - non-resident company - services rendered by the taxpayer to its parent company in USA - business of software product development - TNMM Method - receive actual cost 5 per cent mark up for the software developed and supplied to the parent company - HELD THAT - The area of difference is limited to selection of comparables adopted by the TPO for working out average profit without making adustment for the differences. The taxpayer has further contended that its profit be taken after adjustment of depreciation as per Chapter XIV of the Indian Companies Act. the dispute is restricted to mainly two entities namely, Thirdware Solutions Ltd. and WTI Advanced Technology Ltd. The reasons for exclusion of these two companies and for suitable adjustment while working average profit margin have already been noted. In the case of Mentor Graphics (Noida) (P) Ltd. vs. Dy. CIT. 2007 (11) TMI 339 - ITAT DELHI-H this issue has been thoroughly discussed and it has been laid down that even while applying TNMM, suitable adjustment for difference on account of FAR and other relevant factor is to made. In that decision, the Bench also took into account OECD Guidelines on application of TNMM method. We further find that the provisions on transfer pricing in US also provide for adjustment of the differences while applying a method similar to TNMM. The method is described as 'comparable profit method'. It is evident that both OECD Guidelines and US regulations insist on necessary adjustments for difference on issues affecting profitability. The TNMM may afford a practical solution to otherwise insoluble transfer pricing problems if it is used sensibly and with appropriate adjustments to account for differences of the type referred to above. Similarities and dissimilarities of the transactions under comparison are to be scrutinized to see differences of situations, circumstances and environment. Any difference which materially affects the market value is to be given a serious consideration. The degree of comparability between the tested party and the uncontrolled taxpayer with parameters like nature or line of business, product or service market, the assets composition employed, the size and scope of operation, the stage of business or product cycle are required to be seen. In case of uncontrolled entity, operative income attributable to assets other than assets under consideration is to be adjusted before taking transaction for working mean margin of profit. Income and expenses of the segment of total business may have to be considered. Depending on facts and circumstances of the case, 'it may also be appropriate to adjust the operative profit of tested party and comparable parties'. But when we examine the orders of the Revenue authorities, we do not find that the comparables or the tested parties were scrutinized to find differences, which needed adjustments. We may not agree with the taxpayer that only entities having turnover between Rs. 8 crores to Rs. 18 crores were to be selected for comparison. But we see no justification for considering oversized companies as taken by the TPO. The learned CIT(A) was justified in taking entities having turnover between Rs. 5 crores to Rs. 25 crores but he was in error in considering turnover as the only relevant factor needed to be considered for a proper analysis. The functions performed, assets employed, risk taken (FAR) analysis were also required to be undertaken as per the transfer pricing regulation and other guidelines. This was not done, which renders the comparison as unsound and unreliable. When taxpayer's learned representative had specifically pointed out that companies at Sl. Nos. 16 and 19, namely, Thirdware Solutions Ltd. and WTI Advanced Technology Ltd. were showing extraordinary results and had income from sources other than business of software development, the learned CIT(A) did not care to examine the above contention or to verify the grievances raised by the taxpayer but confirmed the adjustments made. In these circumstances, we are inclined to hold that the approach and the order of the learned CIT(A) was legally incorrect and the order impugned before us cannot be upheld without material changes. A cursory look at the chart in the assessment order of 20 comparables would reveal that the margin of profit shown by Thirdware Solutions Ltd. and WTI Advanced Technology is extraordinary at 67.65 per cent and 54.72 per cent respectively. Therefore, it was necessary for the tax authorities to examine whether these entities have rightly been taken as comparables for application of most appropriate method. We are not in a position to reject the contention of Mr. Ostwal that these companies were trading in software and were giving licenses for use of software. Thus, line of business of these companies was different from the business of the taxpayer involved exclusively in the development of software for its parent company. On facts and material on record, we are of the view that the above two companies were required to be excluded. As per the working given, the profit margin of the taxpayer is quite comparable with average profit margin taken into account by the Revenue other than two companies mentioned above. Therefore, in our opinion, there is no justification for making addition or adjustment for ALP shown by the taxpayer. We further agree with the contention of the learned counsel for the taxpayer that the benefit of adjustment was required to be given in working the margin of profit of the taxpayer for not undertaking any risk in the transactions involved with its parent company. However, evaluation of above risk in the present case is not necessary as even otherwise the margin of profit shown by the taxpayer has fully satisfied the ALP benchmark. The ld DR had also raised some objection to the revised margin of profit shown by the taxpayer by taking lower rate of depreciation. This objection, in our opinion, is without any substance. The depreciation is required to be worked out under the Indian Companies Act and, as provided in the Schedule thereto. Depreciation cannot be computed as per American rules applicable to the parent company. Therefore, Mr. Ostwal was correct in adjusting margin of profit of the taxpayer. Therefore, the addition on account of 'adjustment' in ALP is deleted. No other point was argued before us during the hearing of the appeal. In the result, the appeal of the assessee is allowed.
Issues Involved:
1. Adjustment in the Arm's Length Price (ALP) under section 92CA(3) of the Act. 2. Selection of comparable companies for determining ALP. 3. Methodology and adjustments in computing ALP. 4. Consideration of non-business income in ALP determination. 5. Depreciation adjustments as per Indian Companies Act. 6. Risk adjustments in transactions with associated enterprises. Detailed Analysis: 1. Adjustment in the Arm's Length Price (ALP) under section 92CA(3) of the Act: The taxpayer, E-Gain Communication (P) Ltd., contested the addition of Rs. 1,08,62,537 made by the Transfer Pricing Officer (TPO) for services rendered to its parent company in the USA. The TPO determined that the taxpayer's net profit margin on cost was 5.16%, significantly lower than the average profit of 16.12% from similar uncontrolled transactions. Consequently, the TPO made an adjustment to the ALP, resulting in the addition. 2. Selection of Comparable Companies for Determining ALP: The taxpayer argued that the TPO erred in selecting comparable companies with turnovers ranging from Rs. 8.29 crores to Rs. 360.61 crores, while the taxpayer's turnover was Rs. 10.25 crores. The taxpayer contended that the companies chosen by the TPO were not comparable due to significant differences in turnover and profit margins. The taxpayer further highlighted that some selected companies showed abnormally high profit margins and had income from sources other than software development, making them unsuitable for comparison. 3. Methodology and Adjustments in Computing ALP: The taxpayer and the TPO agreed on using the Transactional Net Margin Method (TNMM) to determine the ALP. However, the taxpayer argued that the TPO failed to make necessary adjustments for differences in functions, assets, and risks (FAR) between the taxpayer and the comparable companies. The taxpayer also pointed out that the TPO did not consider the impact of non-business income on the profit margins of the comparable companies. 4. Consideration of Non-Business Income in ALP Determination: The taxpayer objected to the inclusion of non-business income, such as interest, dividend, and profit on the sale of investments, in the profit margins of the comparable companies. The taxpayer argued that such income should be excluded to ensure a fair comparison. The taxpayer specifically highlighted the cases of Thirdware Solutions Ltd. and WTI Advanced Technology Ltd., which had significant non-business income that inflated their profit margins. 5. Depreciation Adjustments as per Indian Companies Act: The taxpayer contended that the accounts were prepared in accordance with the American rules applicable to the parent company, resulting in higher depreciation claims. The taxpayer argued that depreciation should be computed as per the Indian Companies Act, which would result in a higher operating profit margin of 8.74% instead of 5.16%. 6. Risk Adjustments in Transactions with Associated Enterprises: The taxpayer emphasized that it was a captive company providing software development services to its parent company and did not undertake any significant risks. The taxpayer argued that the TPO failed to account for this lack of risk in determining the ALP. The taxpayer also pointed out that the parent company in the USA had suffered huge losses and could not afford to pay more than cost plus 5% for the services rendered. Tribunal's Findings: 1. Adjustment in the Arm's Length Price (ALP): The Tribunal agreed with the taxpayer that the TPO's adjustment was not justified. The Tribunal noted that the taxpayer's profit margin, after adjusting for depreciation as per the Indian Companies Act, was 8.74%, which was within the acceptable range of ALP. 2. Selection of Comparable Companies: The Tribunal found that the TPO's selection of comparable companies was flawed. The Tribunal agreed with the taxpayer that companies with significantly different turnovers and profit margins were not suitable for comparison. The Tribunal also noted that the TPO failed to consider the impact of non-business income on the profit margins of the comparable companies. 3. Methodology and Adjustments: The Tribunal emphasized the importance of making necessary adjustments for differences in functions, assets, and risks (FAR) between the taxpayer and the comparable companies. The Tribunal referred to the OECD Guidelines and the US regulations, which insist on adjustments for differences affecting profitability. The Tribunal found that the TPO did not make such adjustments, rendering the comparison unsound and unreliable. 4. Non-Business Income: The Tribunal agreed with the taxpayer that non-business income should be excluded from the profit margins of the comparable companies. The Tribunal found that the inclusion of such income inflated the profit margins of companies like Thirdware Solutions Ltd. and WTI Advanced Technology Ltd., making them unsuitable for comparison. 5. Depreciation Adjustments: The Tribunal upheld the taxpayer's contention that depreciation should be computed as per the Indian Companies Act. The Tribunal found that the taxpayer's adjusted profit margin of 8.74% was within the acceptable range of ALP. 6. Risk Adjustments: The Tribunal agreed with the taxpayer that risk adjustments should be made for the lack of significant risks undertaken by the taxpayer in its transactions with the parent company. However, the Tribunal found that even without such adjustments, the taxpayer's profit margin was within the acceptable range of ALP. Conclusion: The Tribunal concluded that the TPO's adjustment of Rs. 1,08,62,537 was not justified and deleted the addition. The Tribunal emphasized the importance of making necessary adjustments for differences in functions, assets, and risks between the taxpayer and the comparable companies. The Tribunal also highlighted the need to exclude non-business income from the profit margins of comparable companies to ensure a fair comparison. The appeal of the taxpayer was allowed.
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