9911796707
TMI Blog2008 (6) TMI 299X X X X Extracts X X X X X X X X Extracts X X X X ..... turnover of Rs. 10,25,68,917 from which it derived profit of Rs. 46,95,254. 3. The AO, after noticing the details of transactions of the taxpayer with its associated concerns, referred the case to the Transfer Pricing Officer (TPO) for computation of ALP as per his letter dt. 5th June, 2006. The TPO, on examination of Form 3CEB i.e., the audit report filed by the taxpayer, found that the taxpayer had claimed that the transactions with its associated concern were carried at arm's length and had claimed on TNMM in support of its claim as under: ---------------------------------------------------------------- Sl. Nature of transaction A.Y. Method A.Y. 2004-05 Method No. and amount used amount used ---------------------------------------------------------------- 1. Receipt for software 11,86,26,462 TNMM 10,25,68,917 TNMM development ---------------------------------------------------------------- 2. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ; 15.45 22.39% Development Consultancy Ltd. --------------------------------------------------------------- 4. FCS Software 67.03 7.15 10.67% 59.91 11.93% Solutions Ltd. --------------------------------------------------------------- 5. Gebbs Infotech Ltd. 14.05 2.73 19.43% 10.62 25.71% --------------------------------------------------------------- 6. Genesys Inter- 21.47 1.78 8.29% 18.34 9.71% national Corpn. Ltd. --------------------------------------------------------------- 7. Geometric Software 63.67 18.73 29.42% 54.71 34.24% Solutions Co. Ltd. --------------------------------------------------------------- 8. Goldstone 57.27 2.71 4.78%&n ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... --------------------------------- 19. WTI Advanced 8.29 4.29 51.75% 7.84 54.72% Technology Ltd. --------------------------------------------------------------- 20. Zenith Infotech Ltd. 18.28 1 5.47% 17.71 5.65% --------------------------------------------------------------- Average 13.29% 16.12% --------------------------------------------------------------- 6. In the light of the above detail, TPO wanted to make adjustment and. therefore, issued a show-cause notice to the taxpayer. The reply of the taxpayer is noted by the TPO as under: (a) E-Gain US pays to the taxpayer an assured income. Therefore, the taxpayer has kept cost plus 5 per cent mark up as consideration for transfer to its parent company. (b) The taxpayer has earn ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... bsp; needs to be saction adjusted + 5% -5% +/-5% analysis 11,91,03,027 10,77,59,881 ----------------------------------------------------------------- 8. Thus, ALP price of sale of software services by the taxpayer to its AE was taken at Rs. 11,34,31,454. However, the taxpayer has sold above services to its AE for Rs. 10,25,68,917 only and accordingly if -5 per cent is taken into consideration. ALP price is Rs. 10,77,59,88. Thus, the taxpayer does not ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ociated concern. The taxpayer also pointed out Ural, its associated concern in USA, had suffered huge losses and could not afford to pay more than cost + 5 per cent benchmark for services rendered by the taxpayer. 13. The determination of net margin ratio with cost at an average figure of 16.12 per cent of comparable entities was thus challenged on the following grounds: (i) The TPO was in error in selecting comparable companies with turnover rangs from Rs. 8.29 crores to Rs. 364.61 crores while the taxpayer's turnover was Rs. 10.25 crores only. Thus, the basis adopted by TPO was not right. (ii) Some of the selected companies had shown abnormally high profit margin and were thus not comparable. Specifically, this objection was taken in relation to comparables at Sl. Nos. 7, 14, 17 and 19 shown in TPO's report. (iii) The TPO further erroneously took into account companies showing high margin of profit of 30 per cent and more listed at Sl. Nos. 7, 16, 17 and 19 of the chart referred to above. 14. The taxpayer further took objection that some companies taken as comparable had income from other sources, quite dissimilar to the income of software shown by the taxpayer. The non-busi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... bsp; 25.71% 4. Genesys Intern. Corpn. Ltd. 9.71% 5. Lifetree Convergence Ltd. 2.57% 6. Thirdware Solutions Ltd. 67.65% 7. VIGIL Consulting Ltd. 2.40% 8. WTI Advanced Technologies Ltd. 54.72% 9. Zenith Infotech Ltd. 5.65% 206.73% Arithmetical mean 22.97% --------------------------------------------- This is much higher than what is worked out by the AO. The submission of the appellant that 5 per cent margin has been k ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... represented the total turnover of the taxpayer. Shri Ostwal further submitted that for computation of ALP both the taxpayer and the TPO accept the applicability of TNMM. With reference to balance sheet and P&L a/c of the taxpayer, he pointed out that accounts were prepared by taxpayer on the lines accounts were prepared in America by the parent company and accordingly much higher depreciation has been claimed in the accounts. He pointed out the difference in rates of depreciation as claimed in the account and as provided in Sch. XIV of the Indian Companies Act. The same is as under: -------------------------------------------------------------- Asset Estimated Rates of Rates as per life years depreciation Sch. XIV -------------------------------------------------------------- Office equipment 5&nbs ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nbsp; (P) Ltd. ------------------------------------------------------------- Profit before tax (A) 3,072,810 Less: - Other income - Dividend ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... evenue expenses - Sub total (C) - Sub total (D) = (B+C) 94,184 Add: - Interest expenses ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ; 8,246,869 Operating cost/Adjusted cost - Total cost as per P&L 99,646,959 Less: Expenses adjustments (as per G above) 5,268,243 Total operating cost 94,378,716 PLJ (adjusted operating profit/adjusted total 8.74% operating cost) ------------------------------------------------------------- 21. Shri Ostwal did not refer to or draw our attention to the transfer pricing study furnished by the taxpayer but contended that even from the working of the TPO, it can be shown that the taxpayer had carried transaction with its associated conc ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... --------------------------------- Deposit w/back-recd. 40,000 ----------------------------------------- Dividend income 4,163,708 ----------------------------------------- 14,155,687" ----------------------------------------- 22. Schedule XIV of the balance sheet further shows that above company was in the trading of software in the relevant period. It was purchasing licenses and clearing them. Purchase and sale of license is not a business which can at all be compared with software business. The balance sheet further makes it clear that the company has paid wealth-tax advance and was not involved in development of technology. It did not have any income from development of software but had income from mutual funds. 23. The second company required to be excluded is WTI Advance Technologies Ltd. showing PBIT of 54.72 per cent. It had incom ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... calculation would work out to 2.98 per cent as against 5.65 per cent taken by the TPO. Effect on profit margin of companies after excluding non-business items (not relating to business of software) of above companies is as under: Statement of computation of revised operating profit margins on operating cost (In millions INR) ------------------------------------------------------------- Particulars Geometric WTI Zenith Thirdware Software Advanced Infotech Solutions Solutions Technolo- Ltd. Ltd. Co. Ltd. gies Ltd. --------------------------------------------------------- ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nbsp; 0.085 ------------------------------------------------------------- Loss on sale of 1.180 Investments ------------------------------------------------------------- Foreign exchange loss 0.011 3.020 (Net) ------------------------------------------------------------- Sub total (E) 0.000 0.014 0.000 4.285 ------------------------------------------------------------- Extraordinary and non-recurring expense ------------------------------------------------------------- Loss on sale/disposal 0.215 0.380 0.712609 of asset ----- ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ------------------------------------- 26. Shri Ostwal further submitted that if Thirdware Solution Ltd. were excluded from comparison as it was carrying on very different functions and had different sources of income, the adjusted operating profit margin of 19 companies taken into account by the CIT(A) would be 10.60 per cent (mean) as per working available at p. 76 of the paper book which is as under; ---------------------------------------------------------------- Sl. Name of company Operating Adjusted No. profit operating &nbs ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... p; 17% 17% 15. Tata Elxsi Ltd. 14.69% 14.69% 16. Visual Soft Technologies Ltd. 32.98% 32.98% 17. VIGIL Consulting Ltd. 2.40% 2.40% 18. WTI Advanced Technologies Ltd. 54.72% 5.90% 19. Zenith Infotech Ltd. 5.65% 2.98% 20. Arithmetic Mean ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ; 0 --------------------------------------------------------- Adjusted operating margin 8.74% 13.22% on cost --------------------------------------------------------- Operating profit/loss 8,246,869 12,473,091 --------------------------------------------------------- Total operating expenses 94,378,716 94,378,716 --------------------------------------------------------- AE transactions 102,568,917 106,851,807 --------------------------------------------------------- +/- 5% adjustment to the -5% ALP as per proviso to s. 92C(2) --------------------------------------------------------- Sales value at arm's length &nb ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d that profit shown by similar software development companies was more than 15 per cent. Learned Departmental Representative submitted that basic onus was on the taxpayer to show that transactions carried with associated enterprises were arm's length transactions. The learned Departmental Representative supported the ALP determined by the TPO who, according to the Departmental Representative, had determined the ALP after discussion with the taxpayer and their representative. Objections on abnormalities or extraordinary circumstances of some comparable transactions were not put before the Revenue authorities. After lot of screening of the relevant data of software companies, 20 comparables were finally selected for ultimate analysis by the TPO and by the CIT(A). In making selection the TPO had taken into account element of risk, loss suffered by companies and gave opportunity to the assessee to show as to how profit margin of 3.86 per cent shown by the taxpayer was comparable. The assessee further could not point out any defect in the transfer pricing analysis carried out by the TPO. No reason has been furnished as to why entities having total range of Rs. 8 crores to Rs. 18 crores ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ied upon and used by the Revenue authorities. He maintained that adjustment made was without any basis and was liable to be deleted. 31. We have given careful thought to the rival submissions of the parties: The taxpayer is a captive company rendering services of software development to its parent company. As per agreement between taxpayer and its parent company, it is to receive actual cost + 5 per cent mark up for the software developed and supplied to the parent company. Both the parties before us accept that TNMM is the most appropriate method for determining ALP in this case. The area of difference is limited to selection of comparables adopted by the TPO for working out average profit without making adjustment for the differences. The taxpayer has further contended that its profit be taken after adjustment of depreciation as per Chapter XIV of the Indian Companies Act. Out of the 20 entities, the dispute is restricted to mainly two entities namely, Thirdware Solutions Ltd. and WTI Advanced Technology Ltd. The reasons for exclusion of these two companies and for suitable adjustment while working average profit margin have already been noted. Learned Departmental Representati ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... lly 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-cl. (i) is established to be the same as the net profit margin referred to in sub-cl. (iii); (v) the net profit margin thus established is then taken into account to arrive at an ALP in relation to the international transaction." 33. Sub-r. (3) of r. 10B requires that the difference between controlled and uncontrolled transactions is to be taken into account for dealing as under: "(3) An uncontrolled transaction shall be comparable to an international transaction if- (i) none of the differences, if any, between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from, such transactions in the open market; or (ii) reasonably accurate adjustments can be made to eliminate the material effects of such differences." 34. It is evident from above that while comparing transactions or enterprises (in case TNMM is applied), the differences which are likely to materially affect the price, cost charged or paid in, or th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... gross margins. These aspects make accurate and reliable determinations of arm's length net margins difficult. Thus, it is important to provide some detailed guidance on establishing comparability for the TNMM, as set forth in sub-s. (c)(1) below. 3.34 Prices are likely to be affected by differences in products, and gross margins are likely to be affected by differences in functions, but operating profits are less adversely affected by such differences. As with the resale price and cost plus methods that the TNMM resembles, this, however, does not mean that a mere similarity of functions between two enterprises will necessarily lead to reliable comparisons. Assuming similar functions can be isolated from among the wide range of functions that enterprises may exercise, in order to apply the method, the profit margins related to such functions may still not be automatically comparable where for instance, the enterprises concerned carry on those functions in different economic sectors or markets with different levels of profitability. When the comparable uncontrolled transactions being used are those of an independent enterprise, a high degree of similarity is required in a number of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the independent enterprises that have a material effect on the net margin being used are adequately taken into account. Many countries are concerned that the safeguards established for the traditional transaction methods may be overlooked in applying the TNMM. Thus where differences in the characteristics of the enterprises being compared have a material effect on the net margins being used, it would not be appropriate to apply the TNMM without making adjustments for such differences. The extent and reliability of those adjustments will affect the relative reliability of the analysis under the TNMM. 37. It is clear that even when TNMM method is applied to determine ALP as per OECD Guidelines, functional profile, assets, assumed risks of controlled and uncontrolled transactions are to be seen while screening. Besides, it is not possible to ignore specific Indian regulations on the subject. We have already noted the relevant sub-rr. (2) and (3) of r. 10B of IT Rules, which specifically require to consider for comparison 'the functions performed, assets employed ... and risks assumed by respective parties'. In r. 10(B)(1)(c) of IT Rules providing for determination through TNMM, it is ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... st plus method. However, the reliability of profitability measures based on operating profit may be adversely affected by factors that have less effect on results under 'the comparable uncontrolled price, resale price and cost plus methods. For example, operating profit may be affected by varying, cost structures (as reflected, for example, in the age of plant and equipment), differences in business experience (such as whether the business is in a start-up phase or is mature), or differences in management efficiency (as indicated, for example, by objective evidence such as expanding or contracting sales or executive compensation over time). Accordingly, if material differences in these factors are identified based on objective evidence, the reliability of the analysis may be affected. (iv) Adjustments for the differences between the tested party and the uncontrolled taxpayers.-If there are differences between the tested party and an uncontrolled comparable that would materially affect the profits determined under the relevant profit level indicator, adjustments should be made according to the comparability provisions of 1.482-1(d)(2). In some cases, the assets of an uncontrolled c ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... . But when we examine the orders of the Revenue authorities, we do not find that the comparables or the tested parties were scrutinized to find differences, which needed adjustments. We may not agree with the taxpayer that only entities having turnover between Rs. 8 crores to Rs. 18 crores were to be selected for comparison. But we see no justification for considering oversized companies as taken by the TPO. The learned CIT(A) was justified in taking entities having turnover between Rs. 5 crores to Rs. 25 crores but he was in error in considering turnover as the only relevant factor needed to be considered for a proper analysis. What about a large number of other factors which materially affect the profit? The functions performed, assets employed, risk taken (FAR) analysis were also required to be undertaken as per the transfer pricing regulation and other guidelines. This was not done, which renders the comparison as unsound and unreliable. When taxpayer's learned representative had specifically pointed out that companies at Sl. Nos. 16 and 19, namely, Thirdware Solutions Ltd. and WTI Advanced Technology Ltd. were showing extraordinary results and had income from sources other tha ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... . Ostwal that these companies were trading in software and were giving licenses for use of software. Thus, line of business of these companies was different from the business of the taxpayer involved exclusively in the development of software for its parent company. On facts and material on record, we are of the view that the above two companies were required to be excluded. The learned counsel has filed results of the comparable companies after excluding above companies. The learned Departmental Representative during the course of hearing or learned CIT(A) in the impugned order did not find any defect in the working furnished by the assessee. As per the working given, the profit margin of the taxpayer is quite comparable with average profit margin taken into account by the Revenue other than two companies mentioned above. Therefore, in our opinion, there is no justification for making addition or adjustment for ALP shown by the taxpayer. 40. We further agree with the contention of the learned counsel for the taxpayer that the benefit of adjustment was required to be given in working the margin of profit of the taxpayer for not undertaking any risk in the transactions involved wit ..... X X X X Extracts X X X X X X X X Extracts X X X X
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