2018 (11) TMI 1120 - AT - Income Tax

Determination of arm s length price (ALP) in respect of an international transaction of rendering software development services by the assessee to its AE - comparable selection - Held that - We uphold the order of the CIT(A) excluding companies by application of turnover filter. We also observe that the TPO has himself applied lower turnover filter of excluding companies with turnover of less than ₹ 1 Crore and in such circumstances, there is no reason as to why he should not apply the higher turnover limit. For the reasons given above, we uphold the order of the CIT(A). Indus Networks Ltd. cannot be regarded as a comparable as it fails the employee cost filter. The reasons given by the CIT(A) for not applying this filter are general and no instances of specific distortion of real employee cost in the comparable companies have been brought out. As already held that employee cost filter of more than 25% of the revenue is a valid filter. Following all we are of the view that inclusion of company should be directed to be considered afresh by the CIT(Appeals) and if the assessee satisfies this filter and otherwise found to be functionally comparable and not excludible on applying other filters, then company be adopted as a comparable. Deduction u/s. 10A - Held that - The decision of the Hon ble High Court of Karnataka in the case of Tata Elxsi Ltd. (2011 (8) TMI 782 - KARNATAKA HIGH COURT) on this issue holding that whatever is excluded from the total turnover while computing deduction u/s. 10A. Disallowance of software expenses on the ground that while making payment for use of software, no tax was deducted at source - Held that - No merits in this ground raised by the assessee in view of the decision in the case of CIT Vs. Samsung Electronics Ltd. (2009 (9) TMI 526 - KARNATAKA HIGH COURT) wherein it was held that payments made for right to use software was payment in the nature of royalty and therefore there was obligation to deduct tax at source while making payment for such use and that the disallowance u/s.40(a)(ia) of the act for non deduction of tax at source was proper. Consequently the disallowance of expenses is upheld.

Issues Involved:
1. Determination of Arm’s Length Price (ALP) for international transactions.
2. Exclusion and inclusion of comparable companies.
3. Application of turnover filter.
4. Exclusion of companies due to abnormal profits or losses.
5. Rejection of employee cost filter.
6. Re-computation of deduction under section 10A.
7. Disallowance of software expenses due to non-deduction of tax at source.

Detailed Analysis:

1. Determination of Arm’s Length Price (ALP) for International Transactions:
The primary issue was the determination of the ALP for the software development services rendered by the assessee to its Associated Enterprise (AE). The assessee used the Transactional Net Margin Method (TNMM) with an Operating Profit to Operating Cost (OP/OC) ratio of 5%. The Transfer Pricing Officer (TPO) rejected the assessee’s study and identified 20 comparable companies with an average OP/TC of 23.65%, leading to a proposed addition of ?5,42,83,208 to the assessee’s income.

2. Exclusion and Inclusion of Comparable Companies:
The CIT(A) excluded nine companies chosen by the TPO due to high turnover or functional differences. These included Celestial Biolabs Ltd., Flextronics Ltd., iGate Global Solutions Ltd., Infosys Technologies Ltd., Mindtree Consulting Ltd., Persistent Systems Ltd., Tata Elxsi Ltd., Wipro Ltd., and Sasken Communication Technologies Ltd. The CIT(A) also included Indus Networks Ltd., which was initially rejected by the TPO.

3. Application of Turnover Filter:
The CIT(A) applied a turnover filter, excluding companies with turnover exceeding ?200 crores, reasoning that the size and economies of scale significantly affect profitability. This was contested by the revenue, but the Tribunal upheld the CIT(A)’s decision, referencing the Tribunal’s previous rulings and the principle that high turnover impacts comparability.

4. Exclusion of Companies Due to Abnormal Profits or Losses:
The CIT(A) excluded Celestial Biolabs Ltd. due to abnormal profits. The Tribunal remanded this issue back to the CIT(A) to consider other comparability parameters, as abnormal profits alone were not sufficient for exclusion without evidence of extraordinary events affecting profitability.

5. Rejection of Employee Cost Filter:
The CIT(A) rejected the TPO’s employee cost filter, which excluded companies with employee costs less than 25% of revenue. The Tribunal, referencing the decision in the case of Misys Software Solutions (I) P. Ltd., upheld the use of this filter, leading to the exclusion of Indus Networks Ltd. from the comparables.

6. Re-computation of Deduction Under Section 10A:
The CIT(A) directed the re-computation of the deduction under section 10A by reducing telecommunication and foreign currency expenses from both the export turnover and total turnover. This was in line with the Karnataka High Court's decision in Tata Elxsi Ltd., later confirmed by the Supreme Court in CIT v. HCL Technologies Ltd.

7. Disallowance of Software Expenses Due to Non-Deduction of Tax at Source:
The Tribunal upheld the disallowance of software expenses under section 40(a)(ia) due to non-deduction of tax at source, referencing the Karnataka High Court’s decision in CIT Vs. Samsung Electronics Ltd., which classified payments for software use as royalty.

Conclusion:
The Tribunal partly allowed the revenue’s appeal and the assessee’s cross-objection. The CIT(A)’s application of the turnover filter and exclusion of certain comparables were upheld, while the issue of Celestial Biolabs Ltd.’s exclusion was remanded for further consideration. The inclusion of Indus Networks Ltd. was reversed, and the disallowance of software expenses was upheld.

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