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TMI Blog2008 (6) TMI 299X X X X Extracts X X X X X X X X Extracts X X X X ..... ase of Mentor Graphics (Noida) (P) Ltd. vs. Dy. CIT.[ 2007 (11) TMI 339 - ITAT DELHI-H] this issue has been thoroughly discussed and it has been laid down that even while applying TNMM, suitable adjustment for difference on account of FAR and other relevant factor is to made. In that decision, the Bench also took into account OECD Guidelines on application of TNMM method. We further find that the provisions on transfer pricing in US also provide for adjustment of the differences while applying a method similar to TNMM. The method is described as 'comparable profit method'. It is evident that both OECD Guidelines and US regulations insist on necessary adjustments for difference on issues affecting profitability. The TNMM 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. Similarities and dissimilarities of the transactions under comparison are to be scrutinized to see differences of situations, circumstances and environment. Any difference which materially affects the market value is to be given a serious consideration. The ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... logy is extraordinary at 67.65 per cent and 54.72 per cent respectively. Therefore, it was necessary for the tax authorities to examine whether these entities have rightly been taken as comparables for application of most appropriate method. We are not in a position to reject the contention of Mr. 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. 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. 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 th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... der: ---------------------------------------------------------------- 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. Purchase of computers 1,93,562 -do- - -do- ---------------------------------------------------------------- Total 10,25,68,917 ---------------------------------------------------------------- 4. The TPO further found that the taxpayer had claimed net profit margin on cost at 5.16 per cent against average profit of 16.12 per cent on similar uncontrolled transactions carried by independent concerns being, similarly computed. 5. The comparable enterprises taken into account for applying Transactional Net Margin Method (TNMM) and Profit Before Income-tax (PEIT) with reference to total turnover and total expenses was taken at 13.29 per cent and 16.12 per cent as per chart below: -------------------- ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ------------------------------------------------ 15. Tata Elxsi Ltd. 153.48 19.71 12.84% 134.18 14.69% tion Technology --------------------------------------------------------------- 16. Thirdware Solutions 23.88 10.06 42.13% 14.87 67.65% Ltd. --------------------------------------------------------------- 17. Visual Soft 153.86 39.3 25.54% 119.18 32.98% Technologies Ltd. --------------------------------------------------------------- 18. VIGIL Consulting 16.06 0.36 2.24% 15 2.40% Ltd. --------------------------------------------------------------- 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 repl ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... der of the TPO was adopted by the AO and assessment was made under s. 143(3) of the IT Act. 10. The taxpayer, being aggrieved, impugned the order of the AO, particularly above adjustment under the transfer pricing, in appeal before the CIT(A). It was submitted that 263 software companies were taken into account in the transfer pricing report submitted by the taxpayer to the TPO. After analysis, 54 companies were selected from the public domain. The basis of rejection of other companies through screening was also furnished to learned CIT(A). The arithmetic mean of total PBIT over income of 54 companies was worked out at 3.86 per cent against similar mean profit of the taxpayer at 4.76 per cent. It was accordingly claimed that the transactions by the taxpayer were carried with associated concern at ALP. 11. The learned representative of the taxpayer accordingly submitted that in 20 companies taken into consideration by the TPO with turnover ranging from Rs. 8.29 crores to Rs. 360.61 crores as against the turnover of Rs. 10.25 crores of the taxpayer was erroneous. It was accordingly submitted that companies taken into consideration by TPO were not comparable. As against the above. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... es at 17.83 per cent and filed the details with the learned CIT(A). If an item of abnormal profit i.e., at Sl. No. 19 was ignored, the resultant profit would work out to only 10.45 per cent, the taxpayer further claimed. 16. The taxpayer accordingly claimed that even from the information gathered and used by the TPO, it was evident that international transactions carried by the taxpayer were at arm's length, and, therefore, adjustments made were without any justification. 17. The learned CIT(A), after considering relevant submission of the parties and after reproducing the chart and basis of adjustment of Rs. 1,08,62,537 by the TPO confirmed the adjustment with the following observations: "2.4 I have considered the submission of the appellant and perused material on record. The appellant has computed the sale price by adding 5 per cent mark up over the total expenditure. The issue to be considered is whether the addition of 5 per cent over the total expenditure may be said to result in sale price which can be said to be at ALP. After taking into account the normal margin in this line of business. I am of the considered view-that there cannot be any doubt that the assessee by ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... sk involved was credit risk, marketing risk, recovery risk, inventory risk, warranty risk, foreign exchange fluctuation risk or post-sale risk. Shri Ostwal further stated that the payment by the taxpayer was received by the taxpayer as per agreement with the parent company E-Gain Communication available at pp. 1 to 8 of the paper book. The agreement provided for services and scope of work as under: "1. Services and scope of work: 1.1 Services: Subject to the provisions of this agreement, EC agrees to accept from ECPL and ECPL agrees to provide to EC, software development services, to design, develop, create, maintain and finetune and produce a computer software or to further develop or change an existing software ('development services') for and on behalf of EC and which shall be defined in the 'statement of work' (hereinafter known as 'statements') issued to and accepted by ECPL. In performing its obligations under this agreement. ECPL shall undertake the development services in India and on customer site on need basis. 1.2 Scope of work: The scope of work shall be outlined in each statement as may be agreed between the parties hereto from time to time. ECPL will provide ade ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 072,810 Less: - Other income - Dividend - Interest 94,184 Lease rent - Profit on sale of investment Prior period income - Foreign exchange gain - Sub total (B) 94,184 Scrap sales - Miscellaneous - Profit on sale of assets - Insurance claims received - Deferred revenue expenses - Sub total (C) - Sub total (D) = (B+C) 94,184 Add: - Interest expenses 10,568 Loss on sale of investments - Foreign exchange loss (net) 1,962,276 Sub total (E) ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... om the public domain with its annual report is available in the paper book. The P L a/c is available at p. 201 of the paper book. On examination of above accounts, it is seen on the receipt side, under the head 'Sales and other income' the taxpayer has shown 'other income' at Rs. 1,41,55,687. The detail given as per Sch. 13 is as under: "Sch. 13: Other income ----------------------------------------- Interest on deposit 2,953,027 ----------------------------------------- Interest on bank deposit 7,600,902 ----------------------------------------- Debtors written back - ----------------------------------------- Other income - ----------------------------------------- Profit on sale of investment 1,180,188 ----------------------------------------- Excess provision w/back 183,400 ----------------------------------------- Interest on IT refund 394,838 ----------------------------------------- Deposit w/back-recd. 40,000 ----------------------------------------- Dividend income 4,163,708 ----------------------------------------- ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Geometric WTI Zenith Thirdware Software Advanced Infotech Solutions Solutions Technolo- Ltd. Ltd. Co. Ltd. gies Ltd. ------------------------------------------------------------- Profit before tax (a) 187.391 42.916 10.668 102.052 ------------------------------------------------------------- Less: ------------------------------------------------------------- Other income ------------------------------------------------------------- Dividend 44.884 1.681 4.164 ------------------------------------------------------------- Interest 17.574 5.609 20.372 10.949 ------------------------------------------------------------- Lease rent 13.727 ------------------------------------------------------------- Profit on sale of 5.292 15.051 Investment ------------------------------------------------------------- Foreign exchange 16.158 gain ------------------------------------------------------------- Sub total (B) 97.634 37.104 5.609 15.112 ------- ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 5.90% 2.98% 62.93% profit/adjusted total operating cost) ------------------------------------------------------------- PLI as calculated by TPO 34.24% 54.72% 5.65% 67.65% ------------------------------------------------------------- Difference -17.81% -48.82% -2.67% -4.72% ------------------------------------------------------------- 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 margins profit margin ---------------------------------------------------------------- 1. 3i Infotech Ltd. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ------------------------------- Sales to non AE 0 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 101,509,217 --------------------------------------------------------- Assessee's sales to associated enterprise are within +/- 5 per cent range." 27. Shri Ostwal further submitted that if Thirdware Solutions Ltd. is excluded, the margin of profit would work out to 8.47 per cent. It was further argued that Indian regulation on transfer pricing as contained in r. 10B, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d 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 should be selected and taken as sacrosanct. The learned TPO has determined ALP after taking into account reliable and cogent material collected from public domain. The argument advanced here and defects in comparable stated before the Tribunal were not stated before the AO or learned CIT(A). The learned Departmental Representative accordingly justified the adjustment made by the AO and upheld by ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... st + 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 Representative is not correct in saying that the objections raised before us were not raised before the Revenue authorities. The objection Ural the companies taken as comparable by the TPO are having income from 'other sources' than the business of software development was not raised but has been noted by learned CIT(A) in para 2.1 of the impugned order. The name of WTI Advanced Technology is specifical ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ) 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 the profit in the open market are to be taken into consideration with the idea to make reasonable and accurate adjustment to eliminate the differences having material effect. If the differences are such that they cannot be subjected to evaluation, then transaction may have to be eliminated for the purposes of comparison. Even r. 10B(1)(c)(iii) requires the adjustment of differences ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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 aspects of the associated enterprise and the independent 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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 clearly provided in cl. (iii) 'the net profit margin referred to in sub-cl. (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 employe ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ipment), 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 comparable may need to be adjusted to achieve greater comparability between the tested party and the uncontrolled comparable. In such cases, the uncontrolled comparable's operating income attributable to those assets must also be/adjusted before computing a profit level indicator in order to reflect the income and expenses attributable to the income, and expense attri ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ng 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 than business of software development, the learned CIT(A) did not care to examine the above contention or to verify the grievances raised by the taxpayer but confirmed the adjustments made. In these circumstances, we are inclined to hold that the approach and the order of the learned CIT(A) was legally incorrect and the order impugned before us cannot be upheld without ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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 with its parent company. However, evaluation of above risk in the present case is not necessary as even otherwise the margin of profit shown by the taxpayer has fully satisfied the ALP benchmark. 41. The learned Departmental Representative had also raised some objection to the revised margin of profit shown by the taxpayer by taking lower rate of depreciation. T ..... X X X X Extracts X X X X X X X X Extracts X X X X
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