2008 (9) TMI 466 - AT - Income Tax

Application of Transfer Pricing (TP) provisions - determination of Arm s Length Price (ALP) - Use of Comparable Uncontrolled Price (CUP) method vs. Transactional Net Margin Method (TNMM) -Principle of Res Judicata in transfer pricing - Adjustments for differences in functions assets and risks -Binding nature of Circular No. 14 of 2001 by CBDT - deduction u/s 92C(2) of the Act - software development services to its AEs - learned counsel for the assessee has argued that the tax payable by it in India is lower than the tax rate applicable to its AE in the Netherlands. Since the assessee is availing the benefit under s. 10A of the Act one cannot take a simplistic view on the matter of tax avoidance. HELD THAT - It is well-settled principle that instructions/circulars issued by the CBDT have a binding effect on the AO. More specifically the binding nature of the abovementioned instruction issued by the CBDT has been confirmed by the Hon ble Delhi High Court in case of Sony India (P) Ltd. vs. CBDT 2006 (10) TMI 88 - DELHI HIGH COURT . Since the circulars issued by the CBDT have a binding effect on the tax authorities Circular No. 14 of 2001 issued by the CBDT would also have a binding effect on the AO/TPO who is duty-bound to demonstrate that the assessee has manipulated its prices to shift profits outside India before any transfer pricing adjustment is made. It is clear that the intention of s. 92C(3) has always been that scrutiny of the international transactions of an assessee can only be done if the AO/TPO can prove that the circumstances enumerated in cls. (a) to (d) are satisfied. Even where any infirmity is identified by the AO/TPO the action of the AO/TPO would be restricted to taking remedial action commensurate with the infirmity identified by him and not beyond. For instance if there is a finding based on evidence for satisfaction of the condition of s. 92C(3)(d) the AO/TPO could at best use his judgment as regards any information/document unreasonably withheld by the taxpayer for the purpose of making the assessment. On the other hand for a case where condition of s. 92C(3)(a) is triggered and not triggering any of the other conditions of s. 92C(3) the AO/TPO has to use the data used by the taxpayer and modify the analysis of the taxpayer only to the extent that the computation of the ALP deviates from sub-ss. (1) and (2) of s. 92C. On a combined reading of ss. 92C and 92D and rr. 10B and 10D it is clear that the data used for the purpose of conducting a comparability analysis should relate to the relevant financial year if the proviso to r. 10B (4) is not attracted ; and be available as on the specified date. It should be noted that both the conditions are cumulative in nature. If any one of the conditions is not satisfied the relevant comparable ought not to be included in the comparability analysis. Sec. 92C r/w r. 10C provide that the ALP of an international transaction shall be determined by any of the five prescribed methods being the most appropriate method. In connection with the above while conducting the TP study the learned counsel had selected the CPM as the most appropriate method after evaluating the criterion laid down in r. 10C(2). In view of the submissions and based on the provisions of the law the learned counsel had argued that the TPO and the CIT(A) have erred in including companies having any related party transactions. Without prejudice to the above contention even if companies having related party transactions were to be included in the set of the final comparables the filter of 25 per cent over sales is ad hoc and without any basis. Further even if it were be assumed that companies with related party transactions could be included on the basis of the 25 per cent filter the learned counsel submitted that the TPO/CIT(A) should have then also rejected two more companies namely Hinduja TMT Ltd. margin computed by the CIT(A) at 111.87 per cent normalized to 32.71 per cent and Xansa India Ltd. margin computed by the CIT(A) at 25.78 per cent on the basis that these companies have related party transactions to the tune of 27 per cent and 99 per cent of their sales respectively. Compare this situation with the AE giving work to a third party service provider during a slow down. The AE might bargain hard on the price and the third party service provider might even agree a lower price just to keep his business going during the slow down. The fact that a captive service provider (a separate and distinct legal entity in India) is assured of business from an AE (another legal entity outside India) and is compensated at a consistent reasonable mark up over costs incurred by it (i.e. the captive service provider) is sufficient to demonstrate that the captive service provider is effectively insulated from all business risks and as such any mark up ought to be only commensurate with the captive service provider s risk taking ability and not beyond. During the course of the hearing the Departmental Representative referred to the commercial agreements to demonstrate that the assessee also carries on pricing risk as there is an overall cap on the fee the assessee can charge to the assessee. Further the TPO in the assessment made for asst. yr. 2002-03 has herself used an industry benchmark of USD 18-25 per hour. If the industry rates are considered as a potential comparable uncontrolled price (CUP) the man-hour rate of the assessee and the consequent value of the international transactions of the assessee with its AE would be at arm s length. Conclusion (i) Since the basic intention behind introducing the TP provisions in the Act is to prevent shifting of profits outside India and the assessee is claiming benefit u/s 10A of the Act the TP provisions ought not to be applied to the assessee. (ii) Circular No. 14 of 2001 issued by the CBDT is binding upon the TPO. (iii) There was no infirmity in the TP study conducted by the assessee and the TPO erred in disregarding the same for the purpose of computing framing the assessment and making the transfer pricing adjustment. (iv) The TPO or the AO needs to satisfy and communicate to the taxpayer the relevant clause u/s 92C(3) which has been triggered by the assessee which has necessitated the application of the TP provisions. In the instant case since this was not demonstrated to the assessee the transfer pricing order is void. (v) The TPO erred in conducting a fresh study for the purpose of passing his order. The study conducted by the TPO is not in conformity with the provisions of rr. 10B(4) and 10D(4). (vi) The TPO erred in disregarding the most appropriate method adopted by the assessee in the TP study and also in using the Prowess database. The TPO did not provide any reason for deviating from the TP study in respect of these matters. (vii) The TP study cannot be ignored by the TPO in the absence of any deficiency or insufficiency. Further the order passed by the TPO appears to have been passed with the intention of making a higher transfer pricing adjustment. (viii) For the purpose of comparability companies with even a single rupee of transactions with AE cannot be considered as comparables. (ix) Adjustment needs to be made to the margins of the comparables to eliminate differences on account of different functions assets and risks. More specifically adjustment needs to be made for (a) Differences in risk profile. (b) Difference in working capital position. (c) Differences in accounting policies. (x) The TPO has grossly erred in normalising the profits of super profit companies. Such companies should have been excluded from the list of comparables. (xi) The proviso to s. 92C(2) of the Act provides a standard deduction of 5 per cent to the taxpayers. The only condition for availing this benefit is that it is subject to the option of the taxpayer. (xii) The decisions of the Tribunal in the cases of Mentor Graphics 2007 (11) TMI 339 - ITAT DELHI-H and E-Gain Communication 2008 (6) TMI 299 - ITAT PUNE-A are squarely applicable to the assessee s case. (xiii) Based on the issues raised and discussed it should be concluded that the transactions of the assessee with its AEs satisfy the arm s length test and that the order of the TPO is bad in law and on facts. (xiv) Without prejudice to the submission of the assessee that the comparables selected by the TPO should hot be considered for the purpose of comparability analysis the assessee has prepared a working carrying out an accept/reject test on the comparables of the TP study as well as the companies selected by the TPO as comparables. Even on the basis of this statement the transactions of the assessee with its AEs satisfy the arm s length test. In the result the appeal is allowed.

Summary

Issues Involved:

1. Determination of Arm's Length Price (ALP).
2. Selection of the most appropriate method for transfer pricing.
3. Use of contemporaneous data.
4. Adjustment for differences in risk profiles.
5. Adjustment for working capital.
6. Adjustment for differences in accounting policies.
7. Exclusion of companies with related party transactions.
8. Application of +/(-) 5% variance as per proviso to s. 92C(2).
9. Applicability of the principle of res judicata.
10. Role of the AO in computing the total income based on the TPO's order.

Summary:

1. Determination of Arm's Length Price (ALP):

The assessee challenged the ALP determined by the TPO, which resulted in a transfer pricing adjustment of Rs. 22,10,80,792. The CIT(A) recomputed the mean margin of the comparable companies at 20.47% and revised the adjustment to Rs. 20,84,81,378.

2. Selection of the Most Appropriate Method for Transfer Pricing:

The assessee selected the Cost Plus Method (CPM) as the most appropriate method, supported by the Transactional Net Margin Method (TNMM) as a supplementary analysis. The TPO, however, preferred TNMM over CPM without providing specific reasons for rejecting CPM.

3. Use of Contemporaneous Data:

The assessee used data available as of 30th Sept., 2003, while the TPO conducted a fresh comparability analysis during January-February 2006, using data not available by the specified date, violating rr. 10B(4) and 10D(4).

4. Adjustment for Differences in Risk Profiles:

The assessee requested adjustments for differences in risk profiles, arguing that as a captive service provider, it bore minimal risks compared to full-fledged entrepreneurial companies. The CIT(A) rejected this claim, stating it was ad hoc and without basis.

5. Adjustment for Working Capital:

The assessee sought an adjustment for differences in working capital, which was not granted by the CIT(A) on the basis that such an adjustment cannot be allowed merely because it was allowed in the succeeding assessment year.

6. Adjustment for Differences in Accounting Policies:

The assessee made adjustments for differences in depreciation rates, which were rejected by the CIT(A) as too simplistic. The CIT(A) did not provide an alternative method for making this adjustment.

7. Exclusion of Companies with Related Party Transactions:

The CIT(A) held that companies with related party transactions exceeding 25% of their total operating income should be excluded. The assessee argued that any related party transaction should disqualify a company from being a comparable.

8. Application of +/(-) 5% Variance as per Proviso to s. 92C(2):

The assessee argued that the proviso to s. 92C(2) allows for a 5% variance from the arithmetical mean, which the TPO and CIT(A) did not apply.

9. Applicability of the Principle of Res Judicata:

The assessee contended that the principle of res judicata should apply since the TPO had accepted the ALP for the previous assessment year (2002-03) using the CUP method. The CIT(A) and TPO took a different view for the assessment year 2003-04 without any change in the facts or operations.

10. Role of the AO in Computing the Total Income Based on the TPO's Order:

The AO computed the total income based on the TPO's order without independently verifying the facts or considering the assessee's submissions, which the assessee argued violated the principles of natural justice.

Conclusion:

The Tribunal allowed the appeal, holding that the assessee's international transactions were at arm's length, and the TPO's order was bad in law and on facts. The Tribunal emphasized the need for adjustments for differences in risk profiles, working capital, and accounting policies, and the application of the +/(-) 5% variance as per proviso to s. 92C(2). The Tribunal also highlighted the principle of res judicata and the AO's role in independently verifying the facts before computing the total income based on the TPO's order.