2012 (4) TMI 120 - AT - Income Tax

Addition u/s 92CA(4) of Rs.1,93,48,372 - A reference u/s. 92CA(1) of the I.T. Act for the Assessment Year 2004-05 was made to the TPO for computation of Arm s Length Price (ALP) in relation to the international transactions carried out by the assessee - TPO noted that the assessee has used TNMM method and its OP/TC comes to 1.8%. By taking comparable margins as per Annexure-I, the TPO noted that the OP/TC ratio comes to 20.42% for the sample set - TPO vide notice dated 24.11.2006 asked the assessee to show cause as to why the mark-up earned by the assessee at 10% upon cost be not considered as under pricing of the services to the parent company as the industry is earning a mark-up of over 30% - It is only after this incomplete list showing lesser profit than the profit declared by the assessee was brought to the notice of the TPO that he excluded the 47 loss making companies to determine the mean average profit at 20.42% - the submission of the Ld. Counsel for the assessee that there is no basis for only excluding the loss making companies and not excluding the high profit making companies or companies which are not at all comparable considering their size, volume of turnover and other factors. In our opinion, the whole exercise of selecting the comparables by the TPO is not proper and is in a haphazard manner - Decided in favor of the assessee Regarding addition of Rs.1,13,84,034/- made by the AO on account of income received from the holding company treated as advance by the assessee deleted by CIT(A) - Held that during the course of assessment proceedings the assessee has given a statement that it has received advance towards market research analysis services rendered during the year - Appeal is partly allowed by way of remand to AO

Summary

Issues Involved:
1. Deletion of addition made by the AO u/s 92CA(4) on account of rendering marketing analysis services in respect of international transactions.
2. Deletion of addition made by the AO on account of income received from the holding company treated as advance by the assessee.

Issue-wise Detailed Analysis:

1. Deletion of Addition Made by the AO u/s 92CA(4):

Facts of the case, in brief, are that the assessee company is engaged in the business of Market Research & Consultancy Services. A reference u/s. 92CA(1) of the I.T. Act for the Assessment Year 2004-05 was made to the TPO for computation of Arm's Length Price (ALP) in relation to the international transactions carried out by the assessee. The TPO issued notice u/s.92CA(2) of the Act requesting the assessee to make a submission to support the ALP computed by it in the Form No. 3CEB. During the year under consideration, the assessee received an amount of Rs.7,15,02,852/- on account of its international transactions by rendering market research analysis services. The TPO noted that the assessee has used TNMM method and its OP/TC comes to 1.8%. By taking comparable margins as per Annexure-I, the TPO noted that the OP/TC ratio comes to 20.42% for the sample set. For this purpose a sample of 102 companies from across a wide spectrum of ITES, software consultancy, market research, business process and outsourcing etc. were chosen including the loss making companies in an un-biased manner from Capitaline Database to arrive at the above result.

The TPO issued a show cause notice to the assessee to explain as to why an appropriate adjustment should not be made to its international transactions. According to the TPO, the assessee sought an adjournment to file the details but no such explanation was filed till the passing of the order. Since the case was getting time barred, the TPO decided the issue on merits and on information available on record and made adjustment of Rs.1,93,48,372/- to the transaction values.

During the course of assessment proceedings the AO asked the assessee to explain as to why the proposed addition made by the TPO should not be made. The assessee requested not to make any additions. Rejecting the explanation given by the assessee, the AO made addition of Rs.1,93,48,372/- as proposed by the TPO.

Before the Ld. CIT(A) it was submitted that the assessee operates through two divisions i.e. (a) Consulting Division (CP) and (b) Global Innovation Centre (GIC). It was submitted that CP division provides consulting services and GIC division provides low and back office support services to global offices of FS-Group through the parent company FS-USA. It was submitted that for the low and back office support services provided to FS-USA, the assessee charges FS-USA on cost plus 10% mark-up. It was submitted that for the services of GIC division, the FS-USA reimburses the assessee all the operating cost of the GIC division and also pays a profit margin of 10% on such cost. It was submitted that the business of the assessee does not involve development of software or software related consultancy services.

It was submitted that during the financial year 2003-04 corresponding to the Assessment Year 2004-05, GIC division of assessee provided low and back office support services to FS-USA and invoiced FS-USA a sum of Rs.7,15,02,852/- on the basis of cost plus 10% mark-up. Challenging the order of the TPO making upward adjustment of Rs.1,93,48,372/- it was submitted that the order was hectic and there is clear and blatant violation of principles of natural justice. It was submitted that on 27.11.2006 the TPO faxed a notice dated 24.11.2006 at 14:57 to the office of the Authorized Representative of the assessee requiring the assessee to show cause as to why mark-up of 10% on cost should not be treated as under pricing of the services to the parent company as according to the TPO the industry is earning a mark-up of 30%. The compliance to this notice was sought by 28.11.2006 i.e. on the very next day. In the said show cause notice it has been mentioned by the TPO that 30.11.2006 was the last date for completing the TP assessments. It was submitted that in the annexure to the show cause notice, there were about 149 companies which the TPO proposed to adopt as comparable companies. However, the Annexure did not contain any details as regards the business activity of these companies, the detailed computation of their respective operating profit margins and how the operations/business activities of these companies were comparable to the back office support services provided by GIC division of the assessee. It was submitted that in a very short time this exercise was not at all possible. Since no reasonable and sufficient opportunity of being heard was granted and since the order of the TPO is in blatant violation of principle of natural justice it was submitted that the same should be treated as void-ab-initio. Various other decisions were also brought to the notice of the Ld. CIT(A) for the above propositions.

Based on the arguments advanced by the assessee the Ld. CIT(A) deleted the adjustment made by the TPO by holding as under:

"12. I have perused the TPO's order, assessment order and written submission filed by the appellant and heard the oral arguments. Transfer Pricing is a systematic, logical and step by step analysis commencing with screening of data for choice of comparables through statistical tools and application of the most appropriate method deciphering the Arms Length Range and culminating in the determination of the ALP.

12.1 Applied to the facts of the case, the TPO selected software companies as comparables when the operation of the appellant did not involve any software related activities. The appellant is engaged in carrying out back office processing work for its Parent Company with risk mitigated manner whereas the TPO has compared its margin with that of companies engaged in high end software development and therefore earning substantially high margins. In any commercial transaction, the compensation paid to a party is a reflection of the functions performed by it, together with the assets employed and the risk assessment. The FAR analysis form the basis of characterizing the tested party and assets in adopting the right comparables for testing the arms length value of the international transactions. Thus, the whole process was inherently flawed since its inception. By merely applying quantitative filters he obtained a set of 102 companies without any further evaluation of the same on the FAR. It is very difficult to digest how TPO found large number of companies (102) from a very wide spectrum of ITES Software consultancy, business research and analytics. BPOs etc as comparable to the appellants back office support business. Such omnibus comparable list betrays a weakness in the screening process. By choosing companies at random he reduced the entire process as a whimsical one.

12.2 The TPO further compounded it folly by applying inconsistent standards to the search process. One quantitative filter it adopted was to reject those companies whose profit margins were more than 100% on cost. However, while computing the arms length profit margin of 20.42% he has included Tanla Solutions Ltd and Indusind Information Technologies Ltd who have margin of more than 100% on cost. The TPO had excluded companies with 50% or more loss but it included more companies with profits of margins of 50% or more. What applies to loss making companies, that they do not operate under Standard Economics circumstances prevailing in the industry should apply to companies earning super profits. The sample of selected comparables generally denotes the range of returns earned by similar companies similarly situated and one in approximation of the industry returns that an uncontrolled entity would expect to earn. Therefore the companies earning too low or too high profits are in the nature of aberrations and should have been excluded from the sample of selected comparables. While the TPO had excluded high (50% or more) loss making companies but he did not make corresponding exclusion of companies earning more than 50% of profits. The absence of any turnover filter/criteria in selecting comparables is also a sore point in the TPO's order. It is common business understanding that if a company's operating profit margin drops then one of the reasons could be that one is selling less number of units/goods/services. Thus turnover is material in a screening process. In any case, there is no justification for taking companies which are 100 times bigger than the appellant in terms of turnover. Obviously they are not in the same league as this company in question. By being in consistent in his approach he was neither fair or reasonable thus further weakened the case.

12.3 The appellant has carried out international comparison with its CP Division which deals with third party customers and does primary work and thus above in the value chain. Whereas the GIC division does secondary work of providing back office support to its AE. It is observed that the division (CP) doing primary work of consultancy has a loss whereas the division (GIC) which deals solely with AE has a profit of 10.02% This further reinforces the stand of the appellant that its price is at Arms Length.

12.4 The appellant has also furnished the US Corporate Income Tax return for calendar year 2003 & 2004 of its AE based at USA. The AE it has observed suffered loss for both the year and has accumulated losses of US $6,586,413 as on 31-12-2004. In contrast the appellant has been compensated at cost plus 10% mark up though the AE has been suffering losses. The economics of the related party transaction has completely been ignored by the TPO.

12.5 Without prejudice to the above, it has also been pointed out that the TPO's instead of applying the margin of 20.42% on operating cost of GIC division which has international transactions, has in reality applied it to the entire cost of the appellant. While this is clearly a mistake apparent from record but it again demonstrates the Cavalier manner in which the whole exercise has been carried out.

12.6 The appellant has also taken an alternative plea that if advances received are considered as income as has been done by the AO then its margins would become 27.54%. The AO by adopting this stand has made the position of the TPO unsustainable. If advance is taken as income then the appellants margin become 27.54% which is more than 20.42% adopted by the TPO. However, since this ground has been agitated separately by the appellant, hence this fact is only mentioned in passing to highlight the overall contradiction in the stand taken by the TPO and the AO.

12.7 The appellant further sought appropriate adjustments for material difference in as much the TPO had selected entrepreneur companies who undertake majority of risk attached to their business whereas the GIC division of the appellant is a captive service provider. The adjustments sought for the differences in the functional and risk profit are (a) General business risk/systematic risk (b) Risk premium for specific rates (c) Marketing and business development etc.

12.8 These contentions of the appellant are not accepted as there is an element of subjectivity and also reliability of comparability adjustments is not free from doubt Such adjustments do not automatically "provide increased levels of comparability" Further it is not clear whether such adjustments consistently increase the reliability of financial results for all comparable companies rather than just some comparable companies. Moreover there is the danger that making sophisticated adjustments create an incorrect impression that the adjusted numbers are "correct" from transfer pricing perspective.

12.9 To sum up, there is a serious violation of the principle of natural justice on the part of the TPO as adequate and proper notice and hearing was not provided to the appellant. The whole exercise of selecting comparables by the TPO was haphazard illogical and random without any FAR. Moreover, there are inconsistencies in standards adopted by the TPO while carrying out the determination of the ALP. The TPO has failed to expose any chinks in the Transfer Pricing study carried out by the appellant and the alternative exercise it has undertaken has gaping holes which cannot be accepted. The appellants AE at USA has suffered continuous losses but still has compensated its subsidiary in India at cost plus 10% markup on a low end back office support services. Thus even without allowing for any adjustments sought on functions risk profile and taking all the above facts and circumstances with its AE is held to be at arms length. The upward adjustment of Rs. 1,93,48,372/- is therefore deleted."

Aggrieved with such order of the Ld. CIT(A) the Revenue is in appeal before us.

The Ld. DR strongly opposed the order of the Ld. CIT(A). He submitted that the Ld. CIT(A) has not at all applied his mind. Referring to para 11.1 to 11.5 of the order of the Ld. CIT(A) which is the submissions given by the Ld. Counsel for the assessee the Ld. DR submitted that the Ld. CIT(A) has simply reproduced the submissions made by the assessee without proper application of mind. Referring to the copy of the order sheet entry, a copy of which is filed in the paper book, he submitted that opportunity has been given to the assessee, therefore, the Ld. CIT(A) was not justified in merely accepting the written submission of the assessee without application of mind. Since the order of the Ld. CIT(A) suffers from so many infirmities he submitted that the same should be set aside and the order of the AO should be restored.

The Ld. Counsel for the assessee, on the other hand, drew the attention of the Bench to Clause 8 of the TPO's order which reads as under:-

"8. On this file information has been sought from US IRS. The information was sought about this assessee's AE's financials and ultimate selling price of business analysis reports in the US market. However, no such information has been received by this office till date. At the same time, it's moving towards the limitation date. Already an adjustment enhancing the ALP value of sale price of services to the AE has been done. In case any more adverse finding is received by this office, suitable rectificatory measure can always be taken."

He submitted that the finding given by the Ld. CIT(A) that when the parent company is incurring losses, therefore, there is no question of the assessee shifting the profit from India to US has not been controverted by the Revenue. Referring to page no. 143 of the paper book he submitted that the show cause notice dated 24.11.2006 was faxed to the office of the Authorized Representative of the assessee. Referring to page nos. 144 to 148 of the paper book he submitted that the TPO had taken the comparables of large number of companies and the GP by TC determined at 28.23% is not the net profit figure. He submitted that the operating profit by TC comes to 8.6%, whereas the assessee has declared 10%. Referring to page no. 185 of the paper book he submitted that the TPO in the analysis has deleted 47 more companies in Annexure-1 of the assessment order treating the same as loss making companies and hence functionally different from the assessee. He submitted that this Annexure was given to the AO during the assessment proceedings. Referring to page no. 188 of the paper book he drew the attention of the Bench to Annexure-2 given by the TPO during the assessment proceedings which is incomplete and contain some fresh sets. Referring to the letter written by the assessee to the TPO on 28.11.2006, he drew the attention of the Bench to the contents of the letter according to which, it was not possible on the part of the assessee to reply to the query raised by the TPO in such a very short notice. He submitted that although the TPO passed order on 13.12.2006, no further notice was issued and no further hearing was granted to the assessee.

Referring to page no. 142 of the paper book, he drew the attention of the Bench to the Profit and Loss A/c for the year ending 31.03.2004 according to which, the CP division was incurring losses and the GIC division was making profit from rendering services to the group concern. Referring to page no. 8 of the paper book he drew the attention of the Bench to the Group Profile. He drew the attention of the Bench to various pages of the paper book which contains the International Transactions at page no. 19, Analysis of Functions and Risk at page no. 20, Comparable Search Process at page no. 38 and the Results of comparables search at page no. 44. Referring to page no. 51 to 105 of the paper book he drew the attention of the Bench to Analysis of Comparable Companies made by the assessee and submitted that no fault has been found by the TPO about the analysis done by the assessee. Referring to the various companies taken as sample by the TPO, he submitted that as against the turnover of Rs.7 crores by the assessee, the TPO has considered companies as comparable whose turnover are more than Rs.100 crores and are giant companies. Relying on a couple of decisions, he submitted that there is no question of comparing giant companies as comparable with that of the assessee company which is a small one. He submitted that if at all any addition has to be made on account of adjustment of ALP, it has to be done only in relation with the transactions with AE's and not with entire transactions. For this proposition he relied on the decision reported in 37 SOT 227. He submitted that when the parent company is incurring losses world wide, therefore, there is no question of the assessee transferring the profit to the US companies. He accordingly, submitted that the order of the Ld. CIT(A) should be upheld and the ground raised by the Revenue to be dismissed.

We have considered the rival submissions made by both the sides, perused the orders of the AO and the Ld. CIT(A) and the paper book filed on behalf of the assessee. We have also considered the various decisions cited before us. We find the TPO vide notice dated 24.11.2006 asked the assessee to show cause as to why the mark-up earned by the assessee at 10% upon cost be not considered as under pricing of the services to the parent company as