9911796707
TMI Blog2007 (11) TMI 339X X X X Extracts X X X X X X X X Extracts X X X X ..... to find comparable transactions as close as possible to the controlled transaction. Besides the assessee has rightly relied upon the transaction in the case of Integrated Hitech Ltd. with operating profit ratio of 3.16%. This transaction has been accepted as comparable by the TPO and, therefore, there is nothing further for the taxpayer to establish that controlled transaction with AE was an arm s length transaction. We are not taking into account high profit or high loss making companies as comparables. All the above, independent comparables have shown profit margin of less than the assessee and, therefore, in the light of above evidence, there is no reason to hold that taxpayer s international transaction with AE is not at arm s length. It has no tangible assets worked in no risk environment are very strong points of the taxpayer, not refuted on record. While holding so, we have not adopted mean profit of several comparable found by respective parties because in spite of our repeated requests, the parties before us, were unable to show us any rule or decision under which average or mean margin (OP/TC) of different companies is to be taken. Tax administration and parties can work ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he relevant provisions and become well-versed with the law on the subject. Any remissness on their part can only be at the cost of the national exchequer and must necessarily result in loss of revenue. At the same time, we have to bear in mind that the policy of law is that there must be a point of finality in all legal proceedings, that stale issues should not be reactivated beyond a particular stage and that lapse of time must induce repose in and set at rest judicial and quasi-judicial controversies as it must in other spheres of human activity. That in the other ground, the taxpayer has raised objection on denial of deduction under section 10A of the IT Act. The question of allowability of claim to the appellant u/s 10A has already been considered and decided in the assessment year 2001 in the case of this very assessee. The Bench, after following the decision of the Tribunal in the case of Legato Systems India (P.) Ltd. v. ITO [ 2004 (11) TMI 294 - ITAT DELHI-E] , restored the matter to the file of the Assessing Officer to make further inquiry and allow deduction to the assessee. The aforesaid decision is directed to be applied in the year under consideration as facts and circ ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... associated enterprises (AEs):- Sl. No International Transactions(IT) With IKOS SYSTEMS USA Book value of the International Transactions 1. Export of Software Development Services 88,866,320 2. Export of Marketing Support Services 3,436,194 4. The taxpayer in order to show that transactions with AEs were arm's length transactions selected Transactional Net Margin Method (TNMM) as the most appropriate method under section 92C of the Income-tax Act and further justified the price charged for services as arm's length price with following certificate in the auditor's report:- "Based on the study, the arithmetic mean of three-year weighted average margins for financial years ended March 31, 2000, March 31, 2001 and March 31, 2002 to the extent available of broadly comparable independent companies calculated using Net Cost Plus Margin as the profit level indicator was compared by the assessee with its three-year weighted average margin for financial years March 31, 2000, March 31, 2001 and March 31, 2002. In the opinion of the assessee its Net Cost Plus Margin, having regard to economic and commercial factors, appears to be arm's length as provided under ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... et and risk (FAR) analysis and of several other independent companies carrying on business of development of software. The taxpayer was taken as the tested party. In it's written submissions the taxpayer further claimed as under: "Based on the functional analysis and understanding of the international transactions with associated enterprises and the available data of comparable companies, the Transactional Net Margin Method (TNMM) using net profit margin based on costs (NCP) as a profit level indicator (PLI), was selected to be the most appropriate transfer pricing method to evaluate these transactions. 12. On the question of search for comparable companies the taxpayer submitted as under:- The objective of the search for comparable companies was to identify from publicly available data, a group of independent companies that undertake software development just as the appellant company. The PROWESS database was employed to identify the potential comparable companies. PROWESS contains financial data of over eight thousand largely publicly traded Indian companies. The idea is collected from annual/quarterly results, Government reports and other sources. The search u ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... c mean 13.41 10. Since the NCP (Profit Margins) of above companies as per average arithmetic mean NCP was 13.41% against 11.07% earned by the taxpayer in the relevant assessment years, it was claimed that taxpayer carried international transaction at arm's length if proviso to section 92C(2) of I.T. Act permitting variation of + / - 5% is kept in mind. It was accordingly claimed that international transaction carried by assessee was at arm's length. 11. The Transfer Pricing Officer refused to accept above claim of the taxpayer. He raised certain objections on the uncontrolled comparable selected by taxpayer in its computation of Arm's Length Price. The TPO also objected to use of data for years other than the financial year involved in question. In order to meet the objections of the TPO, the taxpayer on 8-11-2004 gave fresh computation with reference to the following 16 companies and worked out from relevant data the average net cost margin for financial year 2001-02 at 3.07% against 6.99% disclosed by the appellant. The detail is as under:- S. No. Company Name Net cost plus Margin 1. MYM Technologies 4.81% 2. Kushagra Software -0.49% 3. VJIL Consulting ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... rational Profit % Blue Star Infotech Ltd. 27.18%- Idea space Solutions Ltd. 20.69% Integrate Hitech Ltd. 3.16% NIIT Gis Ltd. 28.80% Quintegra Solutions Ltd. 37.89% Sark Systems India Ltd. 27.91% Teledata Informatics Ltd. 32.99% Average OP/TC 26.94% 14. In response of notice dated 27-1-2005 of the TPO on above operating profit as a benchmark, the taxpayer vide its reply dated 31-1-2005 raised objections as under:- (1) That all the companies selected with the exception of Sark Systems and Quintegra Solutions, have either foreign parent or subsidiary company and are most likely to have related party transactions. (2) That Quintegra Solutions is liable to be eliminated on account of difference in project profile. The TPO on above objections observed that "he was not prepared to eliminate companies having foreign parent or subsidiary company unless value of related party transactions was furnished by taxpayer". The stand of taxpayer that the taxpayer was unable to furnish value of related party transactions as relevant information relating to year 2001-02 was not available in public domain. The TPO accepted the fact that data of relevant year was not available ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ssessee with its AE is worked as under:- Total cost of provision of services by the assessee: Rs. 8,30,64,464 Margin @24.53% of the above: Rs.2,03,75,713 Arms length price to be charged from the AE Rs. 10,34,40,177 7.9 In the manner discussed above the arm's length price of the international transactions entered into by the assessee with its AE is determined at Rs. l0,34,40,177 in place of Rs. 8,88,66,320. 7.10 Accordingly, an adjustment of Rs. 1,45,73,857 is to be made to the income of the assessee, being the difference between the arm's length price and the price charged by the assessee from its AE for rendering services to them. 7.11 As regards the marketing services, the assessee has relied on TNMM with Net Cost Plus (NCP) margin as PLI. On examination of the documentation and the functional analyses contained therein no adverse inference is drawn in respect of this international transaction. Sd/- (HIMANSHU SINHA) JOINT COMMISSIONER OF INCOME-TAX (TRANSFER PRICING OFFICER-I), NEW DELHI" 18. The taxpayer impugned above adjustment/addition on account of transfer pricing (INR 1,45,73,857) in appeal before the ld. CIT(A) and vehemently challenged the r ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ferent Paras. We are not recording all reasons/details as during the course of hearing before us, ld. Representative of the taxpayer agreed that arm's length pricing has to be determined by taking only the data of the current year. He fairly conceded that the Special Bench in the case of Aztec International has also taken the same view and the said view has to be followed by this regular Bench. The ld. CIT(A) also rejected the claim of the Taxpayer that reference made by the Assessing Officer to the TPO under section 92CA(1) was bad in law and, therefore, order of TPO void for want of jurisdiction. This issue was also not agitated ill appeal before us as the same is covered against the taxpayer as per the Special Bench decision referred to above. 20. The ld. CIT(A) had also rejected the claim of the Taxpayer that arm's length price determined by TPO was required to be reduced by 5% in terms of proviso to section 92C(2) of the Act. It was contended that variation of + / - 5% has to be allowed in every case to the taxpayer while making adjustments in international transaction on account of arm's length price in the light of mandate of proviso to section 92C(2) of the Act ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nto account the arithmetic mean of Operating Profit margins over Total Cost (OP/TC) of the above five comparables independent companies having comparable uncontrolled transactions. The arithmetic mean of the OP/TC of these comparable companies was worked out to 24.53%. By applying this arithmetic mean margin of 24.53% to the total cost of provision of software development services amounting to Rs.8,30,64,464, the arm's length price in respect of international transactions of export of software development services to the AE was determined by the TPO at Rs. 1 0,34,40, 177. In fact, initially there would be five arm's length prices if OP/TC of each of above five comparable independent companies is separately applied to the total cost. Thereafter, the arithmetical mean of such five arm's length prices shall be taken as the arm's length price under the proviso to section 92C(2) of the Act. The arm's length price determined by the TPO at Rs.10,34,40,177 by taking the arithmetic mean of OP/TC of all five comparable companies actually represents the arithmetical mean of the arm's length prices under the proviso to section 92C(2) of the Act. 60. As against the ari ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ction is available for comparison determination of the arm's length price is an easy task. However, it is not so in most transactions and rarely is one able to locate an identical transaction. In such cases the arm's length price is determined by taking the results of a comparable transaction in comparable circumstances and making suitable adjustments for the differences. The fundamental requirement, in any of the methods selected, is the selection of "comparables, for benchmarking international transactions. This selection of a comparable should be based on functional, asset, and risk analysis of both the parties and transactions. Whatever methodology is chosen for the purpose of determination of the arm's length price under section 92C, these criteria, as specified in the Act and the Rules have to form a basis of judging the comparability. Thus, there should be a proper analysis of such transactions with respect to the functions performed, the assets employed and the risk assumed by the respective parties with reference to the transaction in question. This can be termed as functional, asset, risk analysis, i.e., FAR analysis. All the three ingredients of FAR ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... er to dispose of this appeal, these are reiterated here:- 25. The comparability of an international transaction i.e. uncontrolled transaction and a controlled transaction is to be judged under rule 10B(2) with reference to the following, namely:- (a) the specific characteristics of the property transferred or services provided in either transaction; (b) the functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to the transactions; (c) the contractual terms (whether or not such terms are formal or in writing) of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions; (d) conditions prevailing in the markets in which the respective parties to the transactions operate, including the geographical location and size of the markets, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition and whether the markets are wholesale or retail. Further caution required to be adopted while looking to the differences between ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ances and by making suitable adjustments for the differences. 26. The first step in the determination of Arm's Length Price is to analyse the specific characteristics of the controlled transaction whether it relates to transfer of goods, services or intangible. Without proper study of specific characteristics of controlled transaction, no meaningful comparison or location of comparable is possible. For example, a mere consideration that controlled transaction relates to "software supply" is not sufficient as there are hundreds of softwares with different characteristics which materially affect their open market value. The characteristics that are required to be considered include in case of transfer of tangible property, the physical feature of the property, its quality, reliability and availability (supply). In case of provisions of services, the nature and extent of services and where tangible property is involved for comparison, the form of transaction. To put it in other words, all the characteristics of the controlled transaction which are likely to affect its open market value must be taken into account. The study should include analysis of functions, risk and ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ) adjustment for risk and growth (c) adjustment of R&D expenses. 27.1 The risk not only due to human resources, infrastructure and quality which are normally taken into account yet more significant risks like market risk, contract risk, credit and collection risk and risk of infringement of intellectual property are being ignored here. In most of the comparable analysis carried in India, the latter type of risk are not being taken into consideration although these can lead to major difference in Market Value of transactions. 27.2 The European tax authorities are reluctant to accept "adjustments" because adjustments necessarily involve consideration of question whether they are appropriate or not and therefore it is always better to find comparable requiring the least or no adjustment. The position in India as per Indian regulations on the subject has been noted earlier. If there are differences which can be adjusted, then adjustments are required to be made. If the difference between the companies are so material that adjustment is not possible, then comparables are required to be rejected. 27.3 Further in the analysis numerous ratio are applied, depending on the spe ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... y parent AE in all intangibles that were provided to the taxpayer for carrying out software development services. The taxpayer emphatically and rightly claimed which is not disputed that it does not own any valuable intangibles, the parent AE had provided necessary intangible such as software and other proprietary tools and process to carry out the software development. All intangibles including discoveries, improvement, inventions and trade secrets conceived or reduced to practice were the sole and exclusive property of the parent AE. The taxpayer only maintained and deployed necessary human resources and infrastructure for development of software. The above stated specific characteristics were required to be considered under the Indian Regulation rule 10B noted above and even under OECD guidelines. However, above characteristics of controlled transactions were evidently not kept in mind by the TPO to find comparable and, therefore, order of TPO/basis of adjustments is not sustainable on above grounds. The TPO committed several minor and major errors while computing the so-called Arms' Length Price. 35. In the first place, while screening and filtering for comparables, he too ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ial year 2001-02 after prohibiting the taxpayer to use data for any year other than financial year 2001-02. The conclusion and the inference that as in data for financial year 2003-04, there was no related transaction, a presumption can be drawn that even in the financial year 2001-02 i.e., two years earlier, there were no inter-party transactions. Such inferences and presumptions are not authorized and cannot be accepted. Assessment under the Act is a judicial act and must be based on cogent material, not on unsound presumption.There is no nexus between the material available on record and the conclusion drawn. Further one wonders and finds no answer to the pertinent question; if data for financial year 2001-02 was not available in the year 2005, as is the admitted position, then how and where from transactions with features as mentioned in para 7.6 of order were found? On facts, we hold that TPO carried search which had serious defects materially affecting the determination of Arms' Length Price and his order cannot be accepted as legally correct. 35.2 Further there is contradiction in the approach of TPO; whereas he rightly insisted in the light of rule 10B(4) that only dat ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... weaknesses of the Transaction Net Margin Method has been compared with other methods and one strong point stated has been overemphasized by the TPO This is what has been stated in para 3.27:- "3.27 One strength of the transactional net margin method is that net margins (e.g. return on assets, operating income to sales, and possibly other measures of net profit) are less affected by transactional differences than is the case with price, as used in the CUP Method. The net margins also may be more tolerant to some functional differences between the controlled and uncontrolled transactions than gross profit margins. Differences in the functions performed between enterprises are often reflected in variations in operating expenses. Consequently, enterprises may have a wide range of gross profit margins but will earn broadly similar levels of net profits." 36.3 Extracts from other paras 3.29, 3.34, 3.35, 3.37 and 3.39 of the same guidelines would clearly show that the inference drawn is one-sided. These paras are as under:- "3.29 There are also a number of weaknesses to the transactional net margin method. Perhaps the greatest weakness is that the net margin of a taxp ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ction similarity. 3.37 Assume, for example, that a taxpayer sells top quality video cassette records to an associated enterprise, and the only profit information available on comparable business activities is on generic medium quality VCR sales. Assume that the top quality VCR market is growing in its sales, has a high entry barrier, has a small number of competitors, and is with wide possibilities for product differentiation. All of the differences are likely to have material effect on the profitability of the examined activities and compared activities, and in such a case would require adjustment. As with other methods, the reliability of the necessary adjustments will affect the reliability of the analysis. It should be noted that even if two enterprises are in exactly the same industry, the profitability may differ depending on their market shares, competitive positions, etc. 3.39 The transactional net margin method 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. The transactional net margin method should not be used unless the n ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... to the fact that the selection made was faulty. It was imperative for the TPO to carryon further analysis and evaluation of companies selected and to see whether this variation is on account of FAR etc. The OECD guideline on this point is as under :- "1.47 Where the application of one or more methods produces a range of figures, a substantial deviation among points in that range may indicate that the data used in establishing some of the points may not be as reliable as the data used to establish the other points in the range or that the deviation may result from features of the comparable data that require adjustments. In such cases, further analysis of those points may be necessary to evaluate their suitability for inclusion in any arm's length range." 38. The TPO neither followed mandatory provision of rule 10B quoted above nor guidelines of OECD and his computation of ALP is patently erroneous. 38.1 In the case of EIDU Pont de Nemours & Co. v. us (1979) 608 F2d 608, the US Court upheld the adjustment made on account of arm's length determination although gross profit in the controlled transaction was comparable to the gross profit of uncontrolled transacti ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t out that all the companies selected were incorporated before the taxpayer except for Zigma Software Ltd. and VGL Softech. It is further submitted that Sark System incorporated in 1998, and which was in operation for less than four years was selected by TPO himself as a comparable company. Therefore, there was no justification for discrediting the comparable selected by the taxpayer. 39.2 The other objection of the TPO that the taxpayer did not exclude companies having high ratio of trading activities and manufacturing activities was also without any basis or justification. The taxpayer while screening for comparable eliminated companies having manufacturing sales greater than 25% of total sales and trading sales greater than 25% to total sales. The TPO, on the other hand, applied a 10% threshold in this regard. The taxpayer has taken pains to show through Table 7 in the paper book that most of the companies satisfied the criteria of less than 10% sale with the exception of three companies i.e. Kushagra Software Ltd., Luminaire Technologies Ltd. and M Y M Technologies Ltd. It is therefore clear that the TPO failed to apply criteria and standards set by him and arbitrarily rejecte ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... adverse comment on 8 companies taken as comparable by the taxpayer. None of the objections raised by the TPO are shown to be applicable to those companies. It is therefore not clear why those companies were not taken as comparable companies. At page 22 of the paper book, the taxpayer has pointed out that arithmetic mean of OP/TC of those companies works out to 4.47% as per the following detail:- S. No. Company OP/TC 1. MYM Technologies 4.81% 3 VJIL Consulting 5.24% 5 Zigma Software 16.38% 6 Sark Systems 30.00% 8 Shine Computech 0.47% 10 Visu Cybertech -2.76% 11 CS Software -25.12% 15 VGL Softech 6.74% 16 Top Media Entertainment No data available Mean 4,47% 41. The taxpayer has also vehemently challenged general observation of the TPO that selected company had a different product profile. The taxpayer has vehemently challenged above interpretation of different profile. 42. Smt. Himalini Kashyap, ld. CIT, DR supported the impugned order of the Transfer Pricing Officer and that of the ld. CIT(A). She argued that comparable as far as possible with reference to data available in public domain were selected by the TPO to fix Arm's length price. There ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he TPO also did not make any adverse comment on the following independent transactions given in the list of comparable by the taxpayer:- Company Name OP/TC 1. MYM Technologies 4.81% 2. VJIL Consulting 5.24% 3. Shine Computech 0.47% 4. VGL Softech 6.74% 46.1 We are not taking into account high profit or high loss making companies as comparables. All the above, independent comparables have shown profit margin of less than the assessee and, therefore, in the light of above evidence, there is no reason to hold that taxpayer's international transaction with AE is not at arm's length. It has no tangible assets worked in no risk environment are very strong points of the taxpayer, not refuted on record. 46.2 While holding so, we have not adopted mean profit of several comparable found by respective parties because in spite of our repeated requests, the parties before us, were unable to show us any rule or decision under which average or mean margin (OP/TC) of different companies is to be taken. Tax administration and parties can work different Arm's length price i.e. a range by the application of different methods. In such a situation, mean of Arm's Length Price ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nt arguments that the conditions of the transaction satisfy the arm's length principle, and that the arm's length range includes their results. If the taxpayer is unable to establish this fact, the tax administration must determine how to adjust the conditions of the controlled transaction taking into account the arm's length range. It could be argued that any point in the range nevertheless satisfies the arm's length principle." 47. Before close, we would like to draw attention to the following . observation of the Supreme Court in the case of Parashuram Pottery Works Co. Ltd v. ITO [1977] 106 ITR 1 wherein it was observed as under:- "It has been said that the taxes are the price that we pay for civilization. If so, it is essential that those who are entrusted with the task of calculating and realizing that price should familiarize themselves with the relevant provisions and become well-versed with the law on the subject. Any remissness on their part can only be at the cost of the national exchequer and must necessarily result in loss of revenue. At the same time, we have to bear in mind that the policy of law is that there must be a point of finality ..... X X X X Extracts X X X X X X X X Extracts X X X X
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