9911796707
TMI Blog2007 (11) TMI 339X X X X Extracts X X X X X X X X Extracts X X X X ..... nd engaged in the business of software development and also rendering marketing systems services to the parent company. The taxpayer filed its return of income for the year under consideration on October 31, 2002 declaring total income at INR 3,99,080 for the financial year 2001-02. The income disclosed included profit from export of computer software to its parent company for which deduction under section 10A was claimed. 2.1 The taxpayer appellant as noted earlier is a software development support service provider. However, software are developed only as instructed by its parent AE. It does not create/develop/sell software products and packages. The software developed by the appellant is used by the parent AE in-house for integrating the same with other software components developed by the parent AE itself. The whole software in turn supports the hardware manufactured by the parent, and sold as a package in the open market by the parent AE. Therefore the appellant's business is limited to providing services of software development support. 3. The accounts and auditor's report of the taxpayer showed that the taxpayer had carried the following transaction with its associa ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... able uncontrolled price (external CUP). The parent company did not receive similar services from any independent third party, nor the taxpayer provided such services to any uncontrolled party and, therefore, internal CUP did not exist. Even external CUP was not available. Average billing rates (man days/man month rate) would vary from technology to technology, from one domain to another and differ according to hierarchy levels, contractual terms, market conditions, geographies and it would not be possible to make adjustment for above factors as also for economic conditions. Above all, all the relevant information is not available in public domain. Therefore, in the circumstances and situation mentioned above, average bill rate, according to the taxpayer was the correct representation of a CUP. The taxpayer having regard to the above worked out net margin of software development transaction INR 88,866,320 (total turnover of Rs. 9,23,02,514) in ratio of total cost at 6.99%. 7. In order to show that above net margin was fair and reasonable and represented arm's length price, the taxpayer claimed it has taken the following steps. It carried its own functional, asset and risk (FAR) ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ying different functions or were involved in controlled party transactions or sale of operation was very low or suffered operational loss of more than 10%. In respect of some, insufficient information was available in public domain regarding their products, functions or financial position. The reasons for elimination of 243 companies are available at page 9 of the paper book filed by the taxpayer. 9. The taxpayer was thereafter left with 16 companies with profit level indicator for financial years 2000 and 2001:- S. No. Name of the Company 2000 2001 1. Top Media Entertainment 9.68 (12.12) 2. Kushagra Software (0.56) 0.0 3. Shine Computech 3.69 5.16 4. M Y M Technologies 11.44 0.93 5. Luminaire Technologies 12.70 6.64 6. O C L Informatics 17.07 6.67 7. Telesys Software 39.81 4.34 8. C S Software Enterprise 22.98 8.54 9. V G L Softech 8.89 15.38 10. Integrated Hitech 14.67 12.37 11. Zigma Software 45.79 1.63 12. Visu Cybertech 5.21 24.74 13. V J I L Consulting 21.34 17.45 14. Sark Systems India 20.56 30.77 15. Fore C Software 47.44 22.12 16. Pentagon Global Solutions 36.99 32.24 Arithmetic mean 13. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... er. The TPO ultimately listed the following companies for elimination from comparison in Para 7.5 of its order:- Name of the company Reason for elimination Kushagra Software Ltd. Manufacturing concern Integrated Hitech Ltd. Low turnover Fore C Software Ltd. Low employee cost Luminaire technologies Ltd. Low turnover Telesys Software Ltd. Low employee cost Pentagon Global Solutions Ltd. Low employee cost. Engaged in manufacturing activity OCL Informatics Ltd. Low turnover 13. The TPO thereafter claimed to have carried independent search of comparable from the PROWESS and CAPITALINE database and NASSCOM directory and worked out the average operational profit for comparison at 26.94% with the following remarks and details in para 7.6 of his order: "The search was conducted for the companies engaged in software development, having turnover between Rs. 50 lakhs to Rs.100 crores, having employee cost of more than 10%, not having manufacturing and trading sales of more than 10% of total sales and not having any related party transactions. After applying such filters, the following set of companies was identified as comparables: Name of the company Operational Profit % ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the assessee. It is found that this company, too, is engaged in software development services and as such is a fit comparable for analysis. Moreover, Transactional Net Margin Method is more tolerant to minor functional differences and is less affected by transactional differences (para 3.27 of OECD report Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, July 1995)." 17. Thereafter, Arm's Length Price of the international transaction and adjustments were worked out at Rs. 1,45,73,857 with the following remarks:- "7.8 In view of the above discussions, the following list of comparable companies are finally chosen for analysis : Name of the company OPTC (F.Y.2001-02) Idea space Solutions Ltd. 20.69% Integrated Hltech Ltd. 3.16% Quintegra Solutions Ltd. 37.89% Sark Systems India Ltd. 27.91% Teledata Informatics Ltd. 32.99% Average OP/TC 24.53% Hence, the arithmetic mean of operating profit over the total cost margins of the comparable companies for the financial year 2001-02 works out to 24.53%. The arm's length price of the international transactions entered into by the assessee with its AE is worked as under:- Total cost ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... AF along with the return of income was not fulfilled. Accordingly, ld. CIT(A) upheld the rejection of claim of Rs. 59,56,330 under section 10A of the IT Act. 19. Thereafter, the ld. CIT(A) considered grievance of the assessee on account of adjustment of Rs. 1,45,73,857 representing the arm's length price. He noted that for the current financial year 2001-02, the taxpayer had chosen Transactional Net Margin Method as most appropriate method to determine arm's length price with Operating Profit margin over Total Cost (OP/TC) as Profit Level Indicator (PLI). The exercise carried by the taxpayer in identifying 16 comparable companies from PROWESS and working of weighted average operating margin of taxpayer and other comparable companies was noted. The ld. CIT(A)accepted that the selection of the method i.e. TNMM as well as PLI i.e. OP/TC were found appropriate by the TPO/AO. The ld. CIT(A) was of the view that taxpayer was not justified in taking into account data for the earlier two preceding years. In his view, only the data for the current year should have been taken into account. He has given detailed reasons in different Paras. We are not recording all reasons/details as ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... on of comparables by the TPO, it would only be appropriate to take note of the finding recorded by ld. CIT(A) on the selection of comparable by the TPO. After noting as to what is required to be done while determining ALP by tax authorities under section 92C/92CA read with Income-tax Rule 10B, the ld. CIT(A) upheld the assessment. His concluding observations are as under:- "58. The contentions of the appellant challenging the reliability and correctness of the comparable uncontrolled transactions are, thus, found to be baseless and without any merit and the same are, accordingly, rejected. On a careful consideration of the facts and circumstances of the case and the relevant position of the law, I am of the considered view that TPO has correctly selected the set of five independent companies having comparable uncontrolled transactions for determination of arm's length price of the international transactions and his action in this regard is, accordingly, confirmed. 59. The arm's length price of the international transactions of export of software development services has been determined by the TPO by taking into account the arithmetic mean of Operating Profit margins ove ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the Assessing Officer was justified in making an addition of Rs. 1,45,73,857 to the total income of the appellant on account of difference between the arm's length price determined by the TPO and the transfer price charged by the appellant from its AE in respect of international transactions of export of software development services and the addition so made by him is, accordingly, confirmed." 22. The taxpayer being aggrieved has impugned the order of the ld. CIT(A) in appeal before the Income-tax Appellate Tribunal (in short Appellate Tribunal). We have heard both the parties and taken into account material on record to which our attention was drawn. In the case of Aztec Software & Technology Services Ltd. v. Asstt. CIT [2007] 107 ITD 141 (Bang.), the Special Bench of five members considered the statutory provisions of Income-tax Act and Rules relating to Transfer Pricing and held as under:- "Computation of the arm's length price is essentially a factual exercise. Each case depends on its own peculiar facts and circumstances. In certain cases where an identical or almost similar uncontrolled transaction is available for comparison determination of the arm's length p ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... would be different if the transfer pricing analysis does not adequately reflect the functions performed and the risks assumed by the enterprise. In such a case, there would be need to attribute profits to the P.E. for those functions/risks that have not been considered." 24. It is true that "transfer pricing" is not an exact science, evaluation of transactions through which the process of determination is carried in an art where mathematical certainty is indeed not possible and some approximation cannot be ruled out, yet it has to be shown that analysis carried was "judicial" and was done after taking into account all the relevant facts and circumstances of the case. Minimum requirement is to prima facie show that controlled international transaction was properly examined, comparable and arm's length price fixed objectively, honestly and in a bona fide manner as required by the statutory regulations. The requirement of the statutory regulation has been thoroughly discussed by the Appellate Tribunal in the case of Aztec Software & Technology Services Ltd, but in order to dispose of this appeal, these are reiterated here:- 25. The comparability of an international transaction ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... number of such transactions is computed having regard to the same base; (iii) the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market; (iv) the net profit margin realized by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii); (v) the net profit margin thus established is then taken into account to arrive at an arm's length price in relation to the international transaction." As noted in the case of Aztec Software & Technology Services Ltd. "rarely one is able to locate an identical uncontrolled transaction". The Arm's Length Price is determined by taking result of a comparable transaction in comparable circumstances and by making suitable adjustments for the differences. 26. The first step in the determination of Arm's Length Price is to analyse the specif ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... al assets employed and assets used to earn profit. The risk assumed by respective parties is a very important consideration. It is a simple principle of economics that the greater the risk, the greater the expected return (compensation). If there are material and significant differences in the risk involved, then the comparable identified are not correct as appropriated adjustments for differences in such cases are not possible. Therefore, while performing searches for potential comparable companies, not only turnover and operating profit but functions performed and risk profile are also to be considered. However, it can always be shown on the given facts of the case that comparable found are similar or almost. similar to the controlled transaction and no adjustments are needed. It is useful to see the level of intangible assets in comparable to an appropriate base. Depending on facts of the case, final set of comparables may need to eliminate differences by making adjustments for the following: (a) working capital (b) 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 ta ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... its AE. The TPO, on the other hand, has worked arithmetic means of OP/TC at 24.53% as noted earlier and determined Arm's Length Price of international transaction at INR 10,34,40,177 leading to addition of INR 1,45,73,857. 32. It is undisputed and fully borne from record that tested party was developing specific software for its parent company, the software developed by the taxpayer was used by parent in-house for integrating the same with other software components developed by itself. The whole software, in turn, supported the hardware manufactured by the parent and sold as a package in the open market. The role of the tested party has been that it is a contract software development support service provider. It is a captive company. 33. Most of the business risk such as contract risk, market risk, credit risk, warranty risk, price risk etc. were essentially borne by parent AE. Normal foreign exchange risk was borne by the taxpayer. 34. The Intellectual Property Right (IPR) was owned by 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 doe ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ed party transactions were not carried in financial year 2001-02 without considering relevant data for financial year 2001-02 as is clearly admitted hereinafter. The TPO has observed:- "The other three companies, proposed to be chosen as comparables did not have any related party transaction in the year 2003-04. Hence, under the same. premise, it has been presumed that these companies did not have any sizeable value of related party transaction in the year under examination and accordingly these comparables were retained for analysis and benchmarking." 35.1 From the above, three facts are clearly established: (1) That in selecting comparables, the TPO chose transactions which included transactions with related parties; (2) The observations that he had carried search and selected parties "not having any related party transaction" made in para 7.6 of order are hollow and untenable; (3) TPO has used data for financial year 2003-04 to verify transactions of financial 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 pr ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... f companies. Ultimately, when five companies were selected by the TPO for comparison, the material on record does not show that TPO cared to know the size of those companies. There is no mention of the characteristics of companies adopted and whether those companies had any intangible properties or what was the ratio of fixed and operating assets. Whether those companies were also low risk companies like that of the taxpayer. Even on prima facie consideration of the companies selected, it is found that PIL variation between them is very wide throwing doubt on correctness of analysis. 36.2 In TPO's views, the Transaction Net Margin Method being more tolerant to minor functional differences, there was no need to carry functional and other analysis to find difference in transactions. For this purpose, he relied upon para 7.27 of OECD report of July 1995. In our opinion, para 3.27 has been taken by TPO out of context. In the Guidelines the strength and 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 transactiona ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... dent enterprise involved in the transactions in order for the controlled transactions to be comparable; there are various factors other than products and functions that can significantly influence net margins. 3.35 The use of net margins can potentially introduce a greater element of volatility into the determination of transfer prices for two reasons. First, net margins can be influenced by some factors that do not have an effect (or have a less substantial or direct effect) on gross margins and prices, because of the potential for variation of operating expenses across enterprises. Second, net margins can be influenced by some of the same factors, such as competitive position, that can influence price and gross margins, but the effect of these factors may not be as readily eliminated. In the traditional transaction methods, the effect of these factors may be eliminated as a natural consequence of insisting upon greater product and function 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. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... pective parties." In rule 10(B)(1)(e) of IT Rules providing for determination through TNMM, it is clearly provided in clause (iii) "the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the difference if any". These regulations have force of law and notwithstanding OECD guidelines, the TPO cannot refuse to consider specific characteristics of transaction, functions performed and assets employed as has been done in this case. Total disregard of regulations non-application of filters as above has resulted in faulty selection of comparison. All sizes of companies have been selected, only commonality being their dealings in softwares. We are unable to hold and approve the approach of TPO as correct. The wide difference in the ratio of operating margins between 3.16% to 37.89% in final selection of comparable by the TPO, is a clear pointer 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 appl ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... rrect turnover figures in the paper book in Table 5 of the synopsis. It has further been pointed out that Integrated Hitech Ltd. has been accepted by TPO in his own selection. It is accordingly argued that comparables selected by the taxpayer fully satisfied INR 50 lakh threshold limit set by the TPO except one company OCL Informatics Ltd. Yet the comparable selected by the taxpayer were held; wrong and not accepted. 39.1 The TPO's objection that taxpayer in the comparative selection of company did not consider the fact that some selected companies were in their initial years. This objection, according to the taxpayer is also without any material. It is submitted that the taxpayer company was incorporated on February 27, 1998 and the year under consideration is the fourth year of its operations. It has given list of incorporation of all other companies to point 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 justifi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... by the TPO. 40. In the end, the assessee appellant has analyzed that even after adopting the criteria/benchmarks set by the TPO for selection of comparables, there are seven companies which satisfy all the criteria and this way, average OP/TC were counted at 6.99%. Table 9 - Appellant's Comparables after applying all of the TPO's Rejection Criteria S. No. Company OP/TC (FY 2001-02 Data) 1. C S Software Enterprise Ltd. -25.12% 2. Integrated Hitech Ltd. 3.16% 3. Reynolds Software Solutions Ltd. (formerly Known as 'Shine Computech Ltd.') 0.47% 4. Sark Systems India Ltd. 27.91% 5. V J I L Consulting Ltd. 5.24% 6. Visu International Ltd. -2.76% 7. Zigma Software Ltd. 16.38% Arithmetic Mean 3.61% 40.1 It is further seen that apart from specifically accepting comparable case of Integrated Hitech Ltd., the TPO did not make any 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 arithmeti ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of approximately 8,000 companies carrying business of software in India and exporting services and goods abroad. It took into account characteristics of its company in question for the relevant assessment year and thereafter made selection of company after applying functional test with reference to assets employed and risk taken by those companies. 46. Though identical transaction could not be located even by the assessee, an attempt was made 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. Besides the above, the 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 pr ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... not be taken as "reliable" comparables for computation of the Arm's Length Price. But no material was brought on record, no arguments advanced to reject the above transaction. Therefore, having regard to facts of the case and material on record, we accept them as comparable and accept the price disclosed by the taxpayer as Arm's Length Price. Consequently, the addition of Rs.1,45,73,857 is directed to be deleted. The view taken by us finds support from para 1.4 of OECD guideline which we quote below:- "1.48 If the relevant conditions of the controlled transactions (e.g. price or margin) are within the arm's length range, no adjustment should be made. If the relevant conditions of the controlled transaction (e.g. price or margin) fall outside the arm's length range asserted by the tax administration, the taxpayer should have the opportunity to present 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X
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