9911796707
TMI Blog2008 (9) TMI 466X X X X Extracts X X X X X X X X Extracts X X X X ..... has been confirmed by the Hon'ble Delhi High Court in case of Sony India (P) Ltd. vs. CBDT [ 2006 (10) TMI 88 - DELHI HIGH COURT] . Since the circulars issued by the CBDT have a binding effect on the tax authorities, Circular No. 14 of 2001 issued by the CBDT would also have a binding effect on the AO/TPO who is duty-bound to demonstrate that the assessee has manipulated its prices to shift profits outside India, before any transfer pricing adjustment is made. It is clear that the intention of s. 92C(3) has always been that scrutiny of the international transactions of an assessee can only be done if the AO/TPO can prove that the circumstances enumerated in cls. (a) to (d) are satisfied. Even where any infirmity is identified by the AO/TPO, the action of the AO/TPO would be restricted to taking remedial action commensurate with the infirmity identified by him, and not beyond. For instance, if there is a finding, based on evidence, for satisfaction of the condition of s. 92C(3)(d), the AO/TPO could, at best, use his judgment as regards any information/document, unreasonably withheld by the taxpayer, for the purpose of making the assessment. On the other hand, for a case where co ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... provider (a separate and distinct legal entity in India) is assured of business from an AE (another legal entity outside India) and is compensated at a consistent reasonable mark up over costs incurred by it (i.e., the captive service provider) is sufficient to demonstrate that the captive service provider is effectively insulated from all business risks and, as such, any mark up ought to be only commensurate with the captive service provider's risk taking ability, and not beyond. During the course of the hearing, the Departmental Representative referred to the commercial agreements to demonstrate that the assessee also carries on pricing risk as there is an overall cap on the fee the assessee can charge to the assessee. Further, the TPO in the assessment made for asst. yr. 2002-03 has herself used an industry benchmark of USD 18-25 per hour. If the industry rates are considered as a potential comparable uncontrolled price (CUP), the man-hour rate of the assessee and the consequent value of the international transactions of the assessee with its AE would be at arm's length. Conclusion: (i) Since the basic intention behind introducing the TP provisions in the Act is to prev ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... plicable to the assessee's case. (xiii) Based on the issues raised and discussed, it should be concluded that the transactions of the assessee with its AEs satisfy the arm's length test, and that the order of the TPO is bad in law and on facts. (xiv) Without prejudice to the submission of the assessee that the comparables selected by the TPO should hot be considered for the purpose of comparability analysis, the assessee has prepared a working carrying out an accept/reject test on the comparables of the TP study as well as the companies selected by the TPO as comparables. Even on the basis of this statement, the transactions of the assessee with its AEs satisfy the arm's length test. In the result, the appeal is allowed. - HON'BLE P. MOHANARAJAN, J.M. AND K.K. GUPTA, A.M. For the Appellant : A.V. Sonde For the Respondent : Etwa Munda, Narendra Kumar and Prabhakar Reddy ORDER K.K. Gupta, A.M. 1. The assessee has filed this appeal agitating the action of the learned CIT(A) in confirming the arm's length price (in short ALP) as determined by the AO in accordance with the TPO's order. 2. The brief facts relating to the agitation can be stated as follows: 2.1 D ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the company is without any basis and ad hoc, and cannot be allowed. (v) Adjustment for working capital cannot be allowed merely on the basis that the same was allowed by the TPO in the succeeding assessment year. (vi) The decision by the Hon'ble Delhi 1ribunal in case of Mentor Graphics (Noida) (P) Ltd. vs. Dy. CIT (2007) 112 TTJ (Del) 408 : (2007) 109 ITD 101 (Del) is not applicable. 2.2 The assessee is in appeal before us in the following grounds: The order passed by the Asstt. CIT under s. 143(3) of the IT Act, 1961 (the Act) and the CIT(A) under s. 250 of the Act, are bad in law and on facts. The CIT(A) erred in determining the arithmetical mean of arm's length net profit margin of 20.47 per cent and a transfer pricing adjustment of ₹ 20,84,81,378. The CIT(A) erred in law in not appreciating the meaning of the phrase 'having regard to' in ss. 92 and 92CA(4) of the Act. The CIT(A) erred in law confirming that the amendment made to s. 92CA(4) vide the Finance Act, 2007 was to set right the lacuna in the said section. The Asstt. CIT having accepted the international transactions of the appellant as being at arm's length in the asst. yr. 2002-03, the CIT(A ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 9;the company') was incorporated in India in September, 1996 as a wholly owned subsidiary of Royal Philips Electronics N.V., Netherlands, Philips Software subsequently merged with 'Philips India Ltd.', an existing 'Philips Group Company', w.e.f. 1 April, 2004. The new merged entity is called 'Philips Electronics India Ltd.' During the previous year relevant to asst, yr. 2003-04, Philips Software had various international transactions which inter alia, included rendering of software development services to overseas affiliates and purchase of hardware/software. 3.2 The software developed by the assessee is only based on the instructions received from its AEs. The assessee does riot create/develop/sell software products and packages. The software developed by the assessee is used by its AEs for integrating the same with other software/hardware components developed by the latter. Therefore, the assessee's business is limited to providing contract software development services. The assessee conducted a TP study in order to comply with the Indian transfer pricing provisions (TP provisions). The assessee provides software development services to its AEs in ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s to its AEs. The profile of the assessee clearly distinguishes it from full-fledged entrepreneurial companies. The assessee selected the CPM as the most appropriate method, inter alia, on the basis that: (a) the services were rendered by the assessee to its AEs under long-term contracts; (b) the costs incurred by the assessee were exclusively incurred for rendering the services; (c) CPM would be appropriate considering the overall functions performed, assets employed, risks assumed and contractual terms; and (d) the selection of CPM as the most appropriate method is. also supported by the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations issued by the OECD ('Organisation for Economic Co-operation and Development') which supports the use of the CPM under the following scenarios: where related parties have concluded joint facility agreements or long-term buy and supply arrangements; or where the controlled transaction is the provision of services. Under the CPM, the arm's length transfer price is determined by identifying the costs incurred by the service provider and adding an appropriate GP margin to the same. The GP margin is usually es ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... from the above table, out of the initial set of 402 companies generated: (a) 331 companies were screened out by the database upon application of the quantitative filters without any human intervention; and (b) 62 companies were screened out upon application of the qualitative filters. 3.5 As is clear from the above discussion, the filters applied by the assessee included: (a) Companies whose turnover is less than ₹ 5 crores and greater than ₹ 250 crores were excluded. (b) Companies carrying out diversified activities were excluded (i.e. companies which were functionally not comparable were excluded); and (c) Companies rendering predominant services to its related parties were excluded. As indicated above, the assessee had screened out companies having a turnover of less than ₹ 5 crores and more than ₹ 250 crores. Companies having turnover of less than ₹ 5 crores were screened out as being too small or companies operating at a nascent/start-up stage. On the other hand, companies having turnover of more than ₹ 250 crores were screened out on the basis that such companies would enjoy economies of scale on the basis of their size of operations. After ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... etical Mean 13.27% -6.75% Philips Software March, 03 28.86% 6.61% Based on the above comparability analysis, since the margins (both gross and net) of the assessee were higher than that of the comparable companies, it was concluded that the transactions for sale of software development services by Philips Software to its, overseas affiliates were at arm's length. 3.7 The following details were filed before the TPO during the course of the proceedings before him: Details Filing reference Page No. of the paper book Copies of the TP Study, audited financial statements for F.Y. 2002-03, computation of taxable income, sample inter-company commercial agreements. Filed vide letter dt.29.8.2005 3-157 a) Sample copies of softex forms for F.Y. 2002-03. Filed vide letter dt. 22.9.2005. 158-220 b) Details of the man-hours worked during F.Y. 2002-03; and c) Updated margins of the comparable companies selected in the transfer pricing study Information relating to variation in contractual terms of business, turnover fitters applied in the TP Study, details relating to on-site visits of the employees and effort sheets maintained by the employees. Filed vide letter dt.10.1.2006. 222-224 Details ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the show-cause notice, vide letter dt. 21st Feb., 2006. 3.8 The TPO passed his order on 15th March, 2006. As against the show-cause notice where the TPO had proposed to recompute the ALP by adopting the arithmetical mean of the margins of the comparable companies as 16.82 per cent, in the order, the TPO computed the ALP by using the mean margin of 21.14 per cent. 3.9 In the order, the TPO dropped seven comparables proposed by him in the show-cause notice, and he arrived at a final set of seven comparable companies (including one company which had also been selected in the assessee's TP study), and computed a net profit margin on costs of 21.14 per cent for these companies (i.e. the TPO applied TNMM in the order). Since the said margin of 21.14 per cent was higher than the corresponding profit margin of the assessee of 5.70 per cent, the TPO recomputed the ALP for software development services at ₹ 1,73,56,31,438. On this basis, the TPO proposed an adjustment of ₹ 22,10,80,792. The eight comparables rejected by the TPO were screened out for the following reasons: Reason No. of companies rejected Companies having diversified activities (i.e., where the revenue from so ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... #39; to the ALP as determined by the TPO. 3.10 The TPO grossly erred in several areas of law and facts. Some of the relevant issues are summarized below: (a) The TPO selected the TNMM as the most appropriate method without providing specific reasons for rejecting the CPM, which was used by the assessee in the TP study. (b) The assessee had used Capita line database for conducting a comparability analysis. The TPO used another database (i.e. Prowess) without giving any reasons. (c) The assessee had followed a methodical search process in the TP study, and arrived at a set of comparable companies which were functionally comparable to the assessee. However, without highlighting any deficiency or insufficiency in the comparables, functionally or otherwise, selected in the TP study, or the search process followed for arriving at those comparables, the TPO has rejected the comparables. In the above context, it would be relevant to note that even in the show-cause notice issued, the TPO had proposed to recompute the ALP on the basis of the comparables in the TP study. However, in the order, the TPO has used a set of comparable companies selected by him, the search process for which has no ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... TNMM as the most appropriate method. In this regard, it is pertinent to note that the assessee has selected the CPM, supplemented by the TNMM in its TP study for both asst. yr. 2002-03 and asst. yr. 2003-04. 3.11 The CIT(A) has observed that before the AO the assessee had merely reiterated the submissions made before the TPO and no additional evidence was placed on record and accordingly, the AO had no alternative but to complete the assessment based on the TPO's order. The CIT(A) further stated that the 'lacuna' in the Act has been 'set right' vide the Finance Act, 2007, by replacing the words 'having regard to' with 'in conformity with' in s. 92CA(4) of the Act. 4. The learned Departmental Representative made submissions summarized as follows: 4.1 The taxpayer has quoted two of the CBDT's circulars explaining the rationale for introducing the TP provisions. The taxpayer has highlighted the part which says that the basic intention underlying the new transfer pricing regulations (TP regulation) is to prevent shifting out of profits by manipulating prices charged or paid in international transactions, thereby eroding the country's tax base ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... justments to approximate arm's length dealings arises irrespective of any contractual obligation undertaken by the parties to pay a particular price or of any intention of the parties to minimize tax. Thus, a tax adjustment under the arm's length principle would not affect the underlying contractual obligations for non-tax purposes between the AE and may be appropriate even when there is no intent to minimize or avoid tax. The consideration of transfer pricing should not be confused with the consideration of problems of tax fraud or tax avoidance, even though transfer pricing policies may be used for such purposes. To sum up, there does not necessarily have to be any pre-conditionality of an intention to minimize or avoid tax in order to make an adjustment to the ALP and even though transfer pricing policies may be used for purposes of tax fraud or tax avoidance, there are other factors that need to be taken into consideration in dealing with transfer pricing. 4.2 With regard to the taxpayer's argument that when its income is exempt under s. 10A, overpricing or under pricing of an international transaction would not affect the computation of its income, the Hon'ble ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nds on the assets employed. Functions performed by a handloom textile unit are different from those performed by a powerloom textile unit, though ultimately both are manufacturing textile and operate in the same business segment. Thus, the nature and quality of assets employed are very basic in determining functional comparability. In the case of Ranbaxy Laboratories Ltd. vs. Addl. CIT (2008) 114 TTJ (Del) 1 : (2008) 299 ITR 175 (Del)(AT), the Delhi Bench of the Tribunal held that, the analysis of comparison should consider total assets employed and assets used to earn profit . 4.4 The learned counsel argued that there is no reference to 'value' of assets in the r. 10B(2)(a) which again shows taxpayer's tendency to raise an argument for arguments sake. The comparability analysis under the TP provisions is databased. It is not based on physical inspection of the units to be compared. Apparently, when rule prescribes that assets employed in any business are to be considered, one has to go by the assets shown in the balance sheet. All the assets, whether tangible or intangible, are given a certain value in the balance sheet. This value may be cost or depreciated value etc. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... on account of single customer risk on the same lines as an independent entrepreneur would claim premium for bearing market risk. 4.8 There are factors at work that actually place a captive service provider in a much higher risk zone. For example, a captive service provider is completely dependent on its AE and any downswing impact in the business of the AE could have a severely damaging impact on the captive service provider. Such is not the case with an entrepreneur who has multiple clients and this diversification actually mitigates risk since a downswing in the business of one client results in a lesser impact on its business as compared to a captive service provider. 4.9 The claim that the captive service providers would be compensated all costs regardless of any work being done or not is only being irresponsible. Every captive service provider normally has a contract with its AE to render the required services. The cost plus remuneration is assured only on rendering of the services to the satisfaction of the AE. No AE enters into a contract stipulating that the captive service provider would be compensated even if no services are rendered. 4.10 In many cases the captive servic ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... - 28% 6. Logix Microsystems - 40% 7. Wipro Ltd. - 28% 8. Tektronics Engg. Ltd. - 40% 9. Mphasis BFL Ltd. - 27% 10. Subex Systems Ltd. - 32% 11. Sanyo LSI Tech. Ltd. - 21% 12. Silver Software - 35% 13. Manhattan Associates Ltd. - 29% 14. Snecma Aerospace Ltd. - 35% 15. Think 3 Design India - 40% 16. Torry Haris Business Soln. - 31% 17. Tavant Tech. Ltd. - 41% 18. MeCreade Software Ltd. - 92% 19. Multitech Software Systems - 25% 20. Spike Infotech - 30% 21. Magnasoft Cons. - 23% 22. S.G. Software Asia - 41% 23. Realsoft Ltd. - 31% 24. Relq Software - 23% 25. Medicom Consultance Services - 83% 4.15 Similar cases are available for the financial year 2002-03 as well. This clearly shows that even a captive service provider can earn margins at par with the independently operated companies. The perceived risk premium is not really a hindrance in earning profits, particularly in the software sector. The software industry is not a capital intensive industry and does not involve a long gestation period, etc. 4.16 The taxpayer has argued that the business risks are borne by the parent company and the Indian subsidiary is only a captive service provider with minimum risk. However, many studies ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... arables in the TP study. The risk profile of the comparable companies selected by the taxpayer is the same as that of the comparables selected by the TPO. In the TP study, the taxpayer neither claimed nor computed any risk adjustment. If the taxpayer's comparables can be accepted than the TPO's comparables should also be accepted because the risk profile of both the comparables set is the same. 4.20 The taxpayer has mentioned various risks such as market risk, product risk, credit risk, etc. However, the taxpayer has not explained whether each of 9 comparables selected by him, bore all the risks enumerated in his submissions. As the comparables selected by the taxpayer had different risk profiles, the taxpayer should have explained which comparable bore what type of risks and how did the same affect its margins. The following table shows the expenditure incurred on selling and advertisement (marketing), R D, etc. by the comparables selected by the taxpayer. The table also shows the bad debts written off or provided for in each case. It can be seen that there is no direct connection between the expenditure incurred on selling and marketing and the profit margin earned. Compa ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 2 In the context of risk adjustments, it may also be kept in mind that the Act presumes that different comparables from the independent enterprises may have varying profit margins depending upon the functions, assets and risk (FAR) profile of each comparable. The comparables selected by the taxpayer had margins ranging from -18.9 per cent (loss) on cost to 30.36 per cent profit on cost. To take care of such differences, the Act provides for adoption of arithmetical mean of varying profit margins of different comparables [proviso to 92C(2)]. Thus, the concept of arithmetical mean takes care of differences arising in the margins of the comparables on account of various factors including risk profile. Thus, there are enough safeguards in the Act which take care of the difference in profit margins of the comparable companies due to risk profile, etc. The discussion on the risk analysis is summarized as under: The taxpayer is totally dependent on the AE for business. Thus, the taxpayer takes the risks associated with heavy dependence on a single customer. In common business parlance it is known as 'single customer risk'. The cost plus agreement with the AE does not guarantee suf ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... sudden increase in the margin from 5 per cent to 10 per cent despite the nature of the services to be rendered and the surrounding circumstances (FAR) remained the same as earlier. This is a very clear proof that the taxpayer had not fixed the price of international transactions at arm's length, but the same were fixed to suit the group's convenience or arbitrarily. 4.23 The taxpayer's claim of being free from various risks is not acceptable. As is discussed above the taxpayer is exposed to single customer risk. The taxpayer has just listed out all types of risk related terms which can be thought of. But, the insinuation that the comparables selected by the taxpayer or the TPO bear all of these risks is not correct. All the selected comparables are contract service providers and hence there is no question of their having any product risk or R D risk or IP risk, etc., basically there are two major differences in the risk profile of the com parables and the taxpayer. 4.24 The taxpayer does not have to indulge into marketing of its services. It can depend on the AE to provide it with business. This issue has already been discussed above that as against the market risk the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... comments except that the comparables selected by the taxpayer were not suitable. No comments except that the conclusion drawn on the basis of a faulty transfer pricing analysis cannot be accepted. 4.28 The taxpayer's claim is wrong that the TPO carried out a fresh search without first rejecting the taxpayer's TP study. In the paras 1 and 2 of the show cause letter dt. 3rd Feb., 2006, the TPO had clarified that the taxpayer had not applied CPM or TNMM in a proper manner. The adjustment asked on account of depreciation claim was not in accordance with the TP provisions. The TPO also clarified that the comparables selected by the taxpayer were not suitable comparables barring one comparable. As the TPO did not accept the taxpayer's analysis, he had no option but to search for new and suitable comparables. The TPO invoked the provisions of s. 92CA(3) in this regard which is perfectly justified. 4.29 In the show cause letter the TPO had also clarified that looking to the availability of the data it was not possible to have a comparability analysis at GP level. Hence, the TPO adopted PBIT as the PLI. It is factually incorrect to say that the TPO did not give his reasons for ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... liminated from the comparables set in the TP study for various reasons. The TPO found that the reasons as cited by the taxpayer were not proper and the companies should have been selected as comparables. Thus, the issue to be decided is suitability of the comparables selected by the TPO and whether rejection of the same comparables by the taxpayer in its TP study was justified. The TPO had not selected any 'new' company which had not earlier been considered by the taxpayer. Therefore, in facts and circumstances of the present case the question as to whether the TPO was right in carrying out a fresh search of the database is of only academic importance. It may also be pointed out here that the search process is not an end in itself. The suitable comparables can be selected in various ways viz., by search of the database, through company websites, publicly available annual reports of the companies, information available in industry surveys, etc. The Act does not prescribe anyone particular way of collecting the data or selecting the comparables. Ultimately, every selected comparable should stand the test of FAR analysis. The taxpayer has to be provided with an opportunity to ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... CPM in the TP study. The taxpayer had also used TNMM as an alternative. The TPO adopted only TNMM. Both the methods are profit based. The CPM compares the companies at GP level whereas TNMM compares at the net profit level. 4.35 For applying CPM, the taxpayer has selected 9 comparables and compared their gross margins after adjustment towards depreciation. The GP margin was computed by reducing the cost of services from the consideration received (Annex. 6 of TP report). The following expenses of the taxpayer were considered as direct and indirect costs cost of services: Employee cost; Travelling and conveyance; Communication expenses; Purchase of software; and Depreciation. The amount spent on rent (Rs. 9.48 crores), power, water and fuel (Rs. 2.35 crores), insurance (Rs. 0.52 crores), repairs (Rs. 5.09 crores), lease and hire charges (Rs. 1.8 crores) and professional charges (Rs. 3.54 crores) were not considered as part of the services. This obviously resulted into a higher GP margin for the taxpayer. 4.36. The TPO rejected the CPM for the following reasons mentioned in the show-cause notice dt. 3rd Feb., 2006 as under: It may be mentioned here that for the purpose of computing g ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... (a) Invoice value will be arrived by adding 5 per cent margin to the total cost incurred for a particular month..... Total cost shall mean all costs incurred by Philips Software Centre (P) Ltd. in this regard, and shall specifically include the personnel costs, travel costs. infrastructure costs (including depreciation on capital equipments). From the above, it is clear that all infrastructure related costs like insurance, repairs and maintenance, lease and hire charges towards equipment and rent form part of costs in rendering services by the taxpayer. In para 4-2-1(b) of the written submissions before the Tribunal the taxpayer has categorically stated that, the costs incurred by the appellant were exclusively incurred for rendering the services . Still the before mentioned expenses have been excluded by the taxpayer while arriving at the cost. So, the TPO correctly rejected the CPM and applied TNMM as all the costs except interest go into providing services by the taxpayer. Even, the OECD Guidelines say as under in regarding the CPM: Cost plus method A transfer pricing method using the costs incurred by the supplier of property (or services) in a controlled transaction. An appro ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the cost of raw materials. Second, there are indirect costs of production, which although closely related to the production process may be common to several products or services (e.g. the costs of a repair Department that services equipment used to produce different products). Finally, there are the operating expenses of the enterprise as a whole, such as supervisory, general, and administrative expenses. 2.41 The distinction between gross and net margin analyses may be understood in the following terms. In general, the CPM will use margins computed after direct and indirect costs of production, while a net margin method will use margins computed after operating expenses of the enterprise as well. It must be recognised that because of the variations in practice among countries, it is difficult to draw any precise lines between the three categories described above. Thus, for example, an application of the CMP may in a particular case include the consideration of some expenses that might be considered operating expenses, as discussed in para 2.39. Nevertheless, the problems in delineating with mathematical precision the boundaries of the three categories described above do not alter ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... MM is applied. The difference between the two methods in the taxpayer's case is thus of only academic interest. Hence, the TPO is correct in rejecting the CPM and applying the TNMM as the taxpayer itself had applied the same as an alternative analysis. Looking at the deficiencies of data for CPM, the TPO had taken TNMM as the most appropriate method. The reasons for rejection of cost plus were conveyed to the taxpayer vide the show cause letter mentioned above. 4.37 It is worthwhile to reproduce the observations of the Hon'ble Supreme Court in the case of Director of IT (International Taxation) vs. Morgan Stanley Co. Inc. (2007) 210 CTR (SC) 419 : (2007) 292 ITR 416 (SC), where the Court held as under: The taxpayer is required to compute the ALP for a transaction using one of the five methods stipulated in the IT Rules. Rule 10C(1) of the IT Rules defines the most appropriate method as the method which is most suited to the facts and circumstances of each particular international transaction. As per r. 10C(2), the most appropriate method has to be selected having regard to a number of factors which are enumerated therein. 4.38 The apex Court has clearly given primacy to r. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... re is no argument on the principle that turnover should be retained as a criterion. The only argument is about whether the turnover range applied by the TPO is better than the turnover range selected by the taxpayer. The taxpayer's turnover was ₹ 151 crores in the relevant year. The taxpayer had applied a turnover range of ₹ 5 crores to ₹ 250 crores however in practice the taxpayer preferred the smaller companies. Out of the 9 comparables selected by the taxpayer only 1 comparable had turnover exceeding ₹ 100 crores. All the other comparables had turnover less than ₹ 100 crores 2 comparables had turnover between ₹ 100 crores and 50 crores. The balance 6 comparables had turnover less than ₹ 50 crores the smallest comparable had turnover of only ₹ 7.41 crores. The TPO found that the taxpayer's selection of the comparables was skewed. 4.42 The TPO therefore applied a minimum turnover limit of ₹ 100 crores and maximum turnover limit of ₹ 250 crores as a criterion. The taxpayer had taken upper side turnover limit of 160 per cent of the taxpayer's turnover of ₹ 151.75 crores. The TPO therefore applied the same ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... up closer comparables and hence, should be accepted as correct. 4.45 In the show-cause notice the TPO had pointed out that even the comparables selected by the taxpayer were showing higher margins than the taxpayer. This does not mean that the TPO had accepted the taxpayer's comparables. In fact, the same show cause letter mentioned the reasons why the taxpayer's comparables deserved to be rejected. 4.46 The filters applied by the taxpayer were not proper filters as can be seen below: (a) The taxpayer excluded companies having significant manufacturing activity without clarifying the meaning of significant. (b) Similarly, a turnover limit of ₹ 1 crore to ₹ 250 crores was applied in an arbitrary manner. Out of the 9 comparables selected by the taxpayer except for M/s Visual Soft all other comparables did not have even half of the taxpayer's turnover. Thus, the selected companies were not comparable in size and turnover to the taxpayer. (c) The taxpayer excluded 36 companies as they were carrying out diversified activities. But, nowhere it is clarified as to what constitutes diversified activities. Companies such as Geometric Software, Infotech Enterprises, e ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... xpayer. The company is a subsidiary of US based Softsol Research Inc. Softsol India's entire sales were to the US company in the financial year 2001-02 and also in the financial year 2002-03 this company cannot be accepted as a comparable. (iv) M/s Orient Inf. is also not an offshore service provider like the taxpayer. Orient is basically an onsite service provider which is apparent from the following details of the employee cost incurred by the company. The living allowance paid to the consultant amounts to 82 per cent of the total cost (Rs. 25.87 crores). The onsite nature of the company is also clear from the balance sheet of the company. An onsite service provider company cannot be compared with the taxpayer who is an offshore service provider. The onsite work is done at the clients place i.e. outside India. The employees have to be paid in line with salary structure of that country. This practically wipes out the margins resulting from the low salary structure prevailing in India. Thus, an onsite service provider company works at relative disadvantageous position. M/s Orient should not have been selected as a comparable. (v) M/s SMR Universal had total revenue of ₹ 4 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... This view is reaffirmed in para 35.2 of the order as under: 35.2 Further, there is contradiction in the approach of TPO; whereas he rightly insisted in the light of r. 10B(4) that only data for the financial year was relevant but for his own use, he has taken into account data for financial year 2003-04 i.e. relating to two years later. It can be seen that the transfer pricing analysis involves three different stages. (i) First stage is when the taxpayer enters into the agreement with the AE and the actual international transaction takes place. At this time the taxpayer determines the transfer price as per the prevailing business conditions and economic environment and the groups transfer pricing policy. At this stage the taxpayer does not have the contemporaneous data available. (ii) The second stage is when the taxpayer undertakes the transfer pricing analysis as required by the Act and files the 3CEB report. This is a post facto exercise. The taxpayer has to use the contemporaneous data as available to him at the time. The provisions of r. 10D(4) are applicable at this stage. But, at this stage the taxpayer is not permitted to use earlier year's data unless the conditions m ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... a is not applicable to income-tax proceedings including transfer pricing proceedings. This legal position has been confirmed in various judicial decisions. One of the recent judgments on the issue is the order of the Tribunal, Lucknow 'B' Bench in the case of Jaiprakash Investments (P) Ltd. (ITA No. 787/Luck/2005 order dt. 25th Jan., 2008). The determination of ALP is a fact based exercise. The selection of the most appropriate method and suitable com parables depend on the availability of facts. The availability of facts may differ from year-to-year and depending on the availability of facts different methods may also have to be chosen in different years. The facts in the case of selected comparable companies may also change. A company may not have related party transactions in one year, but may have them in the next year. The companies may change their business or may get acquired by different companies, etc. All these changed facts would have a bearing on selection of comparables. Therefore, it is quite likely that some of the comparables chosen in the earlier year may not qualify the test of uncontrolled transaction in the succeeding year. Thus, in transfer pricing proc ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 9; and 'in conformity with' before and after amendment to s. 92C(4). The CIT(A) has discussed this issue at para 7 and para 12 of her order. In this connection, the observations made by the Hon'ble Tribunal, Bangalore Special Bench in the case of Aztec Software Technology Services Ltd. in para 51, p. 67 are of relevance and are therefore reproduced below: We are, therefore, of the opinion that TPO's order under sub-s. (3) of s. 92C cannot be treated as final and binding on the AO. Having said so, we do not mean to suggest that order of TPO is of no value or consequence. The words 'having regard to' convey definite meaning and are strong enough to enjoin upon the AO to pass an order and adopt transfer pricing as determined by the TPO unless there are very good grounds to modify or alter the transfer pricing ordered by the TPO. Only after recording reasons, as above, the AO can take the transfer price other than one determined by the TPO. There may be cases in which the assessee, after ALP is determined by the TPO and before his order is made the basis of assessment, may get such authentic material to show that transfer pricing determined by the TPO is not cor ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... assessment is to be made having regard to the report of the TPO which is required to be considered with other relevant material available on record. There is nothing to suggest that TPO's report on transfer pricing is conclusive and debars AO from looking at any other material. The aforesaid conclusion is also in line with latest change made in s. 92C by the legislature through the Finance Act, 2007. Sub-s. (4) of s. 92CA has been substituted with the following sub-section w.e.f. 1st June, 2007: [(4) On receipt of the order under sub-s. (3), the AO shall proceed to compute the total income of the assessee under sub-s. (4) of s. 92C in conformity with the ALP as so determined by the TPO]. 53. Now, words 'having regard to' have been replaced by words 'in conformity with'. So, now, AO after introduction of sub-s. (4) above is required to pass assessment order in conformity with the order of the TPO determining ALP. Now the order of the TPO has been expressly made binding on the AO. From the above it is clear that there was a lacuna in the Act as appropriate language was not used earlier. This has been modified and w.e.f. 1st June, 2007, the order of TPO is binding ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ot been determined in accordance with sub-ss. (1) and (2), or information and documents relating to the international transaction have not been kept and maintained by the assessee in accordance with the provisions contained in sub-s. (1) of s. 92D and the rules made thereunder, or the information or data used in computation of the ALP is not reliable or correct; or the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by a notice issued under sub-s. (3) of s. 92D. If anyone of such circumstances exists, the AO may reject the price adopted by the assessee and determine the ALP in accordance with the same rules. However, an opportunity has to be given to the assessee before determining such price. Thereafter, as provided in sub-s. (4) of s. 92C, the AO may compute the total income on the basis of the ALP so determined by him. The Board's circular referred to by the taxpayer also states that the taxpayer's ALP can be accepted only if the data used is reliable and correct. In this case, it has been demonstrated by the TPO as well as by the CIT(A) that the data used by the payer was not correct. The circular d ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nature of the business i.e., software development service this approach of the taxpayer appears to be correct and acceptable. 4.59 However, when comparing profits at enterprise level and clubbing together all the transactions a question arises about the treatment to be given to some of the transactions which the comparable company might have carried out with its associate concerns and other related parties. Practically speaking almost every company or business concern would have related party transactions such as salaries paid to directors, sale purchase with associated concerns etc., though the quantum and effect of such transactions on the overall margins may vary from case to case. If such transactions with the related parties are significantly affecting the overall enterprise level profits of that company, then certainly that company would have to be excluded from the list of comparables. On the other hand if the related party transactions constitute a minor and insignificant part of the overall turnover, then the same may not affect the overall margins of the company and hence that company may still be retained as a comparable subject to functional similarity. 4.60 To overcome ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... owever, if the related party transactions do not have material effect on the overall profit margins then still that company can be considered as a comparable. The Act does not provide directly as to what percentage of related party transactions can have material effect on the overall margins. But, however, some guidance can be taken from definition of the AE in s. 92A(2)(a) wherein it is prescribed that one enterprise holding 26 per cent shares in the other enterprise can be considered as an AE. Similarly, in the provisions of s. 40A(2)(b) the person having substantial interest is described as a person carrying not less than 20 per cent of voting power in that company. Thus, it is seen that 20 per cent or 26 per cent interest is considered as substantial interest. As the provisions of s. 92A(2)(a) are from the transfer pricing chapter itself, a limit of 25 per cent may be considered more reasonable to be applied as the threshold limit for the related party transactions. If the limit is reduced further it would only result in eliminating more and more companies. On the other hand, if the limit is relaxed then companies with predominantly related party transactions would get included ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ng from, such transactions in the open market; Related party transactions less than 25 per cent of the turnover cannot materially affect the overall profit margin of the company. Hence, such companies can be selected as comparables under TNMM. 4.64 The TP provisions or the OECD Guidelines do not prescribe profit margin as a comparability criterion. No comparable should be rejected or accepted on the basis of its profit margins. Comparability analysis should be based purely on similarity of the nature of services rendered or goods sold/purchased, functions, assets employed in the business, economic conditions, etc., therefore the taxpayer's argument that companies with higher margins should have been excluded is not in accordance with the TP provisions. The TPO had resorted to normalization of the profits of some of the comparables only in order to take a liberal view in the whole matter. To some extent the normalization of profits compensated for various risk adjustments was asked for by the taxpayer. The taxpayer should not have any grievance. There was a substantial difference between the employee cost to sales ratio in the case of the taxpayer and in the case of the two comp ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... apparently belongs to the software industry. The taxpayer has taken an argument repeatedly that the comparables selected by the TPO were engaged in diversified activities. The taxpayer has referred to various verticals of software development in which these comparable companies are engaged. Here, we may see that the companies selected by the taxpayer were also engaged in diversified activities and different verticals of software. Hence, verticals of software were never a criterion of comparability either in the taxpayer's selection or the TPO's selection. Thus, the TPO's comparables cannot be found fault with on this account. The comparables selected by the taxpayer were engaged in diversified activities as mentioned below. Lanco Global renders services in the following sectors: Solutions IT Governance, Compliance Security Services Enterprise Resource Planning SAP Oracle eBusiness Applications Customer Relationship Management Business Intelligence Dataware house Implementations Application Development Upgrade Migration Application Management Services Infrastructure Support Services Testing QA Business Process Outsourcing M/s Melstar has following to say about its functi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ere also engaged in diversified fields of software development. The same criterion was applied by the TPO. Adjustment on account of depreciation, the issue had been discussed by the CIT(A) at para 8.7 of her order. 4.66 The taxpayer asked for adjustment on account of depreciation on the ground that the taxpayer had charged depreciation at higher rate than the comparables. This is not acceptable for the following reasons: (A) Under the TNMM these type of adjustments are not required. OECD Guidelines describe the strength and weakness of TNMM as under: One strength of the TNMM 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 GP margins. Differences in the functions performed between enterprises are often reflected in variations in operating expenses. Consequently, enterprises may have a wide range of GP margins but still earn broadly similar levels of net profits. The taxpayer has also give ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the depreciation rates for different class of assets are different, one uniform rate cannot be applied to all the assets. The adjustment worked out by the taxpayer on the basis of average rate of depreciation is thus not acceptable. (C) The taxpayer has consistently applied depreciation @ 43 per cent on a straightline method. Consequently, the closing WDV of assets in the case of the taxpayer is reduced to that extent, whereas in the case of other companies who are following lower depreciation rates, the decrease in the value of assets each year is also less to that extent and consequently, the closing WDV of assets remain relatively higher. In other words, though the taxpayer had applied depreciation at higher rate, the base (opening WDV of assets) is much lower, whereas in the case of comparable companies depreciation though applied at a lower rate, is applied on a higher base. Thus, the effect of higher depreciation rate is considerably reduced. If any adjustment/normalization of depreciation has to be worked out, it must be worked out minimum for the last three years, so that the base effect can be neutralized. (D) One way to tackle the problem of differences in depreciation ra ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ion and amortisation (EBITDA) may be the most reliable measure, and that it may be appropriate to exclude book intangible assets from the analysis, as such book intangible assets are typically the result of acquisitions, and do not include internally developed intangibles. 138. Depreciation and amortisation can pose difficult comparability issues, for instance, if two parties own and/or use comparable intangibles, but one has acquired them and amortised them overtime, while the other has developed them and expensed them upfront. 139. For this reason, some commentators suggest that depreciation and amortisation ought to be excluded from the determination of the net profit margin indicator. On the other hand, in asset intensive industries where assets are key value drivers, excluding depreciation and amortisation might not lead to a meaningful outcome, and depreciation and amortisation would not be excluded if it can be reasonably assumed that they do not create material comparability issues. Where uncertainties of that type are material, the third party comparable concerned might have to be rejected. Where no or insufficient satisfactory comparables are available to apply the consid ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... As per r. 10B(1)(e)(i), the net profit margin earned by the tested party from an international transaction is computed in relation to the costs incurred or sales effected or assets employed or having regard to any other base. The provisions of r. 10B(1)(c)(i) also allow selection of any appropriate base for comparing the margins. Thus, in the taxpayer's case PBDIT can be adopted as PLI, if the taxpayer still feels that the depreciation is making a significant effect on the margins. 4.68 The taxpayer has referred to the decision of Pune Tribunal in the case of E-Gain Communication (P) Ltd. In the said decision, the Tribunal had not actually approved the computation of the adjustment. The Tribunal merely held that such an adjustment may be granted in the facts of the case. The Tribunal however did not say that average rate of depreciation should be applied to the comparable companies. On the contrary, the Tribunal held that the taxpayer's (tested party) margin may be reworked out by applying lower depreciation rates as per the Companies Act. This may be applied in the present case provided the taxpayer can establish that the finally selected comparables as approved by the Hon ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... The taxpayer did not compute the same during the transfer pricing proceedings. If the Hon'ble Tribunal decides that the same has to be allowed the matter may be remanded to the AO/TPO for actual computation. 4.72 The CIT(A) has discussed the applicability of Mentor Graphics decision in her order in detail. In brief, (a) The Tribunal upheld the use of contemporaneous data. The para 19 of the order dealing with contemporaneous data is reproduced below: The learned 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 during the course of hearing before us, learned 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 has also taken the same view and the said view has to be followed by this regular Bench. This view is reaffirmed in para 35.2 of the order as under: 35.2 Further, there is contradictio ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e taxpayer were grossly dissimilar to the taxpayer. Hence, TPO rejected the same. (f) The Tribunal held that companies having related party transactions should not be taken as comparables. The TPO tried to follow this and excluded such companies as per the data available at the time. (g) The Tribunal held that suitable adjustments should be allowed to the taxpayer for differences in risk, etc. It must be pointed out that in the present case the plea for making adjustments on account of risk and working capital was not made at any time during the assessment proceedings and the claim was made before the CIT(A) for the first time. The taxpayer's claim of 5 per cent risk adjustment was without any proper basis. This has already been discussed above. (h) The Tribunal also gave some directions on functional comparability but the same are not very specific. In the Mentor's case the Tribunal finally accepted the taxpayer's comparables which included a trading company. Thus the Tribunal's discussion on functional comparability actually does not lay down norms or guidelines on the subject. 4.73 In the present case, the taxpayer as well as the TPO have selected comparables fro ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... that PIL figures of Integrated Hitech or other four companies were wrong or on account of their FAR analysis, these entities could not be taken as reliable comparables for computation of the ALP. 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 ALP. Consequently, the addition of ₹ 1,45,73,857 is directed to be deleted. The view taken by us finds support from para 1.4 of OECD Guidelines 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 administrati ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... on shall be determined by any of the following methods, being the most appropriate method,......' Similarly, heading of r. 10C is 'most appropriate method' not methods. The rule also refers to most appropriate method in singular only. Rule 10(D)(1)(i) also mentions only one most appropriate method selected by the taxpayer as under: 'a description of the methods considered for determining the ALP in relation to each international transaction or class of transaction, the method selected as the most appropriate method along with explanations as to why such method was so selected, and how such method was applied in each case.' In the statutory 3CEB Form also, the term used is 'most appropriate method' and not methods. The aspect of the most appropriate method and average mark up of comparable companies was discussed by the Hon'ble Supreme Court in its order in the case of Director of IT (International Taxation) vs. Morgan Stanley, where the Court held as under: 'The taxpayer is required to compute ALP for a transaction(s) using one of the five methods stipulated in the IT Rules. Rule 10C(1) of the IT Rules defines the most appropriate method as the m ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Tribunal's observations are therefore contrary to the explicit provisions of the Act. It also appears that there was no controversy regarding adoption of arithmetical mean in the present case. This was not one of the grounds of appeal to be decided by the Tribunal. Before concluding it is also clarified that the Tribunal decision in the case of Mentor Graphics was essentially based on the peculiar facts of the case. The Hon'ble Tribunal allowed the taxpayer's appeal because of certain omissions and mistakes on the part of the TPO. This aspect is discussed at paras 34 to 41 of the Tribunal order. 4.78 In brief the Tribunal found that: (a) The TPO erred in considering the data for the financial year 2003-04 while determining the related party transactions in the case of comparables of the financial year 2001-02. (b) The TPO had adopted contradictory approaches by rejecting the taxpayer comparable for being not based on contemporaneous data while himself using data of the subsequent years for comparability. (c) The TPO did not look into FAR analysis of the comparable companies. (d) The TPO rejected 8 of the taxpayer comparables without making any specific comments. (e) The ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ad also used earlier year data. Following the Aztec order, with due respect, the Tribunal should not have accepted the taxpayer's TP study but should have redetermined ALP afresh or should have directed the TPO to determine ALP afresh. It appears from the Tribunal's order that the Tribunal did not undertake a fresh transfer pricing analysis because the Tribunal was convinced that as one of the com parables had a PLI which was lower than the taxpayer's PLI hence there was no need for any adjustment or fresh transfer pricing analysis. It has already been discussed above at para 17.5 that the Tribunal's approach on the issue is not in line with the provisions of the Act. Had the Tribunal not followed this approach, it is apparent that the Tribunal would have undertaken a fresh transfer pricing analysis to determine the ALP. 4.82 The taxpayer is a part of the software industry in India. It is worth mentioning that Nasscom survey of the software industry in India revealed that on an average, industry operating margins were 26 per cent on sales i.e., 35.13 per cent on cost in the year 2005-06. The major part of the IT industry in India consists of software exports i.e., 7 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... to furnish information relating to controlled international transactions, select a suitable method for determination and furnish ALP of such international transactions carried by it and give basis and supporting authentic evidence of ALP and adjustments made. The taxpayer has further to co-operate in the determination of the ALP by the tax authorities by furnishing all relevant information. The tax authorities in cases where they are of the opinion that ALP has not been correctly determined by the taxpayer, can substitute their own ALP on the basis of material or information furnished by the assessee or collected by them. However, such ALP has to be determined having in mind provisions of ss. 92 and 92C and other rules and regulations. While determining ALP, tax authorities are bound to follow principles of natural justice and be fair and reasonable to the taxpayer. Any material collected to be used against the taxpayer is to be put to taxpayer to explain. Having regard to the purpose of the legislation and application of similar enactment world over, it must further be held that adjustments made on account of ALP by tax authorities can be deleted in appeal only if the appellate au ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... also have to be relaxed. The entire search criterion would change and the TPO as well as the taxpayer should be allowed to search for the comparables within the new turnover limits if any determined by the Tribunal. During the course of hearing before the Hon'ble Tribunal, it was argued by the taxpayer that the turnover range of ₹ 100 crores to ₹ 250 crores would throw up more than 200 software companies. This appears to be factually incorrect. Even today, the databases do not show more than 20 to 30 software companies in this turnover range. However, if the taxpayer is correct, then the Hon'ble Tribunal may direct the taxpayer to produce the list of the 200 software companies having turnover between ₹ 100 crores to ₹ 250 cores so that suitable comparables may be searched from these companies. The taxpayer has argued against the 'significant' related party transactions filter, stating that the word 'significant' is TPO's innovation. The fact is that the taxpayer himself had applied a filter of rejecting companies having 'predominant' related party transactions. However, the taxpayer did not clarify the meaning of 'pre ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... including real-time systems, components based software engineering, multithreaded architecture and ASIC design methodologies in deep sub-micron technologies to drive the creation of tomorrow's products and services. PSCPL is an ISO 9001/Tick IT, SEI CMM SM Level 5 company and has emerged as a critical partner in the development of a range of Philips products ..... PSCPL has built up extensive know-how and expertise in the software engineering and technology domains relevant to its business. PSCPL's software expertise is primarily in the areas of embedded and information system engineering, architecture design, programming and testing. PSCPL's IC design expertise is in the areas of logic and circuit design. In addition, competencies in the areas of project management, requirement engineering and quality assurance have been established to offer customers, products and services of the highest quality, at the fastest time to market and at the lowest cost of ownership..... Philips Research (PR) PR Group is called design technology for Trile S. Software, Silicon and system. The research activities at PR will align to the international research program, embedded platform and ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... y distinguishable on facts on the abovementioned Tribunal decisions relied by the taxpayer. The taxpayer has argued it should be allowed benefit of +/(-) 5 per cent range as per the proviso to s. 92C(2). It is submitted that the issue has been dealt with in detail by the CIT(A) in her order. The taxpayer's reliance on the Tribunal's decision in the case of Development Consultants (P) Ltd. is of no avail, because in that case no arguments were relied on this issue either by the Department or by the taxpayer. The computation of the ALP as submitted by the taxpayer before the Tribunal was not refuted by the Departmental Representative and hence was approved by the Tribunal as under 22. The learned AR Submitted that in case of AY 2003-04, the arm's length GP/Sales of the comparable companies is 28.22% which is lower than the GP/Sales of DCIL for the year ended 31 March 2003 of 61.10% indicating that DCIL has retained more than the arm's length margin at the gross level. He stated that transfer pricing legislation as provided in the IT Act allows a taxpayer to have an option to compute the ALP which may vary from the IT Act which states that where more than one price is ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... h its bankers and no nationalized banks would give such credit limits to a paper company. DCIL has been established after proper permission obtained from the RBI. Hence, based on the facts and our findings we can conclude that DCIL is a company of substance and is performing fullfledged distribution activities. It is not a paper company established to evade taxes as argued by the CIT(A) in his order. Hence, we do not find any justification in the arguments of the CIT(A) that entire profits should come to the assessee and DCIL should not retain profits. Further, the benchmarking exercise and analysis conducted by the assessee has been examined by the CIT(A) and the TPO, but they have not been able to controvert the analysis of the assessee. Therefore, we conclude DCIL should retain the gross margins as determined through the benchmarking exercise by the assessee, discussed earlier in this order. Therefore, based on such analysis, in case of asst. yr. 2003-04, the amount of adjustment in the ALP of the international transactions entered by the assessee with DCIL should be restricted to USD 275,632 as submitted and conceded by the learned Authorised Representative. This amount convert ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... hifted profits) to an overseas jurisdiction for the purpose of avoiding tax in India. The reference by the Departmental Representative to the proviso to s. 92C(4) is completely out of context and irrelevant. The Departmental Representative ought to have appreciated that the proviso comes into play only once a transfer pricing adjustment is made. By quoting OECD Guidelines, the learned Departmental Representative does not get much help. The learned Departmental Representative ought to have appreciated that what is relevant in the Indian context is the specific provisions of the Circular No. 14 of 2001. As submitted above, at para 55.5 of the said circular, the CBDT has clearly mentioned that the intention of the TP provisions is to curtail avoidance of taxes by shifting profits outside India. 5.2 Further, the learned Departmental Representative's argument on DDT is not on solid ground and has no bearing on any motive of shifting profits. This is clear from the fact that it is not uncommon for companies to use retained earning for expansion in India. The arguments of the Departmental Representative on motive for avoiding DDT would fail in such a scenario. While making the argumen ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... provisions of transfer pricing in the Act, vide Finance Act, 2001. Relevant extract of the CBDT circular is reproduced as under: 55.5 The new provision is intended to ensure that profits taxable in India are not understated (or losses are not overstated) by declaring lower receipts or higher outgoings than those which would have been declared by persons entering into similar transactions with unrelated parties in the same or similar circumstances. The basic intention underlying the new transfer pricing regulations is to prevent shifting out of profits by manipulating prices charged or paid in international transactions, thereby eroding the country's tax base. 5.5 As per the above-mentioned circular, the TP provisions ought to be applied to cases where shifting of profits happens outside India by manipulation of prices. In the instant case, the TPO/AO did not establish, either before initiating the transfer pricing proceedings or even at the time of concluding the proceedings, that the assessee had manipulated prices to shift profits outside India. In this connection, the learned counsel drew our attention to Instruction No. 3, dt. 20th May, 2003 [(2003) 261 ITR (St) 51] issued ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 77; 5 crores or not. If it is more, he has also to grant approval in the light of directions of CBDT. These directions are mandatory and binding on the AO and the CIT(A). The fact that directions are not binding on the assessee or Courts is immaterial. The relevant question to be answered is whether circulars are binding on the Departmental authorities. The question has an obvious answer. The issue of legality and validity of above directions was raised before Hon'ble Delhi High Court in the case of Sony India (P) Ltd. Their Lordships have also upheld validity of directions of CBDT. 45. In the light of above discussions, we do not find any illegality in the directions issued by the CBDT. Since the circulars issued by the CBDT have a binding effect on the tax authorities, Circular No. 14 of 2001 issued by the CBDT would also have a binding effect on the AO/TPO who is duty-bound to demonstrate that the assessee has manipulated its prices to shift profits outside India, before any transfer pricing adjustment is made. Sec. 92C(3) provides that the AO may proceed to determine the ALP if he is of the opinion that certain conditions have been satisfied. Relevant extracts of the said s ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... y such circumstance exists. In all other cases, the value of the international transaction should be accepted without further scrutiny. Based on the above mentioned para, it is clear that the intention of s. 92C(3) has always been that scrutiny of the international transactions of an assessee can only be done if the AO/TPO can prove that the circumstances enumerated in cls. (a) to (d) are satisfied. Even where any infirmity is identified by the AO/TPO, the action of the AO/TPO would be restricted to taking remedial action commensurate with the infirmity identified by him, and not beyond. For instance, if there is a finding, based on evidence, for satisfaction of the condition of s. 92C(3)(d), the AO/TPO could, at best, use his judgment as regards any information/document, unreasonably withheld by the taxpayer, for the purpose of making the assessment. On the other hand, for a case where condition of s. 92C(3)(a) is triggered, and not triggering any of the other conditions of s. 92C(3), the AO/TPO has to use the data used by the taxpayer and modify the analysis of the taxpayer only to the extent that the computation of the ALP deviates from sub-ss. (1) and (2) of s. 92C. Comparison ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e with sub-ss. (1) and (2), or information and documents relating to the international transaction have not been kept and maintained by the assessee in accordance with the provisions contained in sub-s. (1) of s. 92D and the rules made thereunder; or the information or data used in computation of the ALP is not reliable or correct ...... Further, even in the case of Mentor Graphics, the Tribunal, at para 39.4 of the order have observed as follows: The TPO could have carried fresh search only if the comparables drawn by the taxpayer were insufficient or had other deficiency. The Act and the Rules provide that while conducting the comparability analysis, the data to be used should be contemporaneous. In this regard, the requirement of law is two-fold: (a) Data to be used for analyzing the comparability of an uncontrolled transaction shall be the data relating to the financial year in which the international transaction has been entered into [r. 10B(4)]; and (b) Amongst other things, the data which is used for the comparability analysis should exist latest by the specified date [r. 10D(4)]. It is important to note that r. 10B(4) casts an obligation on the taxpayer to conduct the compa ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... that the provisions of r. 10D(4) do not override the provisions of r. 10B(4). Thus, inter alia, the data for financial year 2002-03 shall be used, even though the same was not available by the specified date. For the reasons as discussed above, the assessee submitted that the above observation of the CIT(A) is clearly contrary to the provisions of rr. 10B(4) and 10D(4). The assessee therefore submitted that the TPO/CIT(A) is not justified in: (a) conducting a fresh comparability analysis during the course of the assessment; and (b) using non-contemporaneous data, i.e., data which was not available as on the specified date. It would not be out of place to quote the following observation of the OECD on this matter: Each taxpayer should endeavor to determine transfer prices for tax purposes in accordance with the ALP, based upon information reasonably available at the time of the determination. The learned counsel for the assessee does not deny that as per r. 10B(4) and proviso thereof, data relating to the previous two financial years may be used, provided such data has an influence on computing the ALP. The reference by the Departmental Representative to the decisions of Aztec Soft ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... very person who has entered into an international transaction shall keep and maintain such information and documentation, in respect thereof, as may be prescribed.... Further, the operative portion of r. 10B reads as follows: (1) Every person who has entered into an international transaction, shall keep and maintain the following information and documents, namely,..... On a combined reading of ss. 92C and 92D, and rr. 10B and 10D, it is clear that the data used for the purpose of conducting a comparability analysis should relate to the relevant financial year [if the proviso to r. 10B (4) is not attracted]; and be available as on the specified date. It should be noted that both the conditions are cumulative in nature. If any one of the conditions is not satisfied, the relevant comparable ought not to be included in the comparability analysis. 5.9 Another example of the Departmental Representative's argument that the provisions of r. 10D(4) do not have a bearing on r. 10B(4) is completely erroneous is that cl. (g) of r. 10D(1) relates to records of the comparability analysis, as mentioned in r. 10B. The Departmental Representative's interpretation gives a preference to r. 10 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... l Net Margin Method (in short TNMM) in its TP study. However, while conducting his comparability analysis and passing the order, the TPO did not provide any reasons for rejecting the CPM, which was selected as the most appropriate method by the assessee. Further, the TPO selected the TNMM as the most appropriate method, without sharing with the assessee any analysis, basis or reasons which led him to: (a) select the TNMM as the most appropriate method; and (b) reject CPM, as selected by the assessee, as the most appropriate method. Secs. 92D and 92E cast a responsibility on the assessee to prove that the requisite transfer pricing documentation, including the comparability analysis has been conducted and maintained by the assessee. Likewise, where a transfer pricing assessment is conducted by the TPO/AO under s. 92CA or 92C(3), it is the duty of the TPO/AO to prove that such documentation maintained by the assessee is deficient or insufficient in any manner. Only if such deficiency or insufficiency is found in the documentation, the TPO/AO can conduct a scrutiny. In this regard, relevant extracts of the CBDT Circular No. 14 of 2001 are produced below: ... Where such onus is dischar ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... hics. At para 39.4 of the said order, the Tribunal has observed as follows: The TPO could have carried fresh search only of the comparables drawn by the taxpayer was insufficient or had other deficiency. Further, reference in this connection could also be made to the decision of the Madras High Court in the case of CIT vs. K. Sankarapandia Asari Sons (1980) 19 CTR (Mad) 264 : (1981) 130 ITR 541 (Mad). 5.11 A look at the show-cause notice referred to by the Departmental Representative clearly shows that the argument of the Departmental Representative is erroneous as in the said notice, no reasons were given for rejecting CPM as the most appropriate method. Further, neither were any reasons set out in the order of the TPO and nor has the Departmental Representative suggested that the reasons have been given elsewhere. 5.12 In the TP study, the assessee had carefully evaluated the five prescribed methods, and based on the facts, the assessee selected CPM as the most appropriate method. The analysis of the assessee is documented in pp. 85 and 86 of the paper book. The Departmental Representative has referred to the observation of the Supreme Court, out Of context: The Supreme Court' ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ere the assessee has followed a methodical process while conducting the TP study, with a recognized database and a correct approach. (b) the approach followed by the assessee is in consonance and in conformity with the requirements of the law; and (c) there is no shortcoming or deficiency in the approach of the assessee. There is no reason as to why the TPO/AO should conduct a fresh transfer pricing analysis, completely disregarding the approach of the assessee which is acceptable in law. The assessee submits that the approach followed by the TPO/CIT(A) to reject the TP study of the assessee and to select a set of new companies is against the provisions of the Act/Rules and is based on their whims and fancies. 5.14 The learned counsel had submitted that if a methodology/basis/assumption/database adopted by the assessee is not found unacceptable by the TPO, the TPO cannot change the same merely on a whim or because he prefers otherwise. In this regard, reference could also be made in the Madras High Court in the case of CIT vs. K. Sankarapandia Asari Sons. 5.15 The learned counsel reiterates that for the TPO ought to have: (a) questioned the database used by the assessee; (b) questi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... visions of r. 10B(2), are as under: (i) Characteristics of property or services; (ii) Functional analysis; (iii) Contractual terms; (iv) Economic circumstances; and (v) Business strategies. From the above, it is clear that the focus is on the functions performed and the reference to other economic criterion is only in the context of the functions. It would also be relevant to note that in the order, the TPO has admitted that the comparables are functionally similar. The relevant extract is reproduced below: Even though the comparables selected in the TP document are functionally similar, their cases used in the business are grossly dissimilar to those of PSCPL..... However, even after admitting that the comparables in the TP study are functionally similar to the assessee, the TPO has rejected the comparables in the TP study. Quantitative filters of turnover and asset base. 5.17 The learned counsel had argued that the TPO has erred in rejecting the comparables in the TP study, merely on the basis of comparison of the asset base and the turnover of the companies. completely ignoring the fact that the comparables were the ones which survived a structured filter/elimination process, an ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ected. At this juncture, it would also be relevant to take note of the following observations of the Pune Bench of Tribunal in the case of E-Gain Communication (P) Ltd. vs. ITO (ITA No. l685/Pn/2007) [reported at (2008) 118 TTJ (Pn) 354 : (2008) 13 DTR (Pn) 65-Ed.] at para 36. p. 34 of the order: The learned CIT(A) was justified in taking entities having turnover between ₹ 5 crores to ₹ 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 was also required to be undertaken as per the transfer Pricing regulation (TP regulation) and other guidelines. This was not done, which renders the comparison as unsound and unreliable. Independent of the above, the TPO has considered M/s Visualsoft Technologies Ltd. as a comparable company. As submitted during the course of the hearings, it should be noted that M/s Visualsoft Technologies has significant R D expenses (i.e., 4.61 per cent of the revenues)-refer to p. 15 of the annual report for the period 2002-03, at ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s performed, assets employed, risk taken (FAR) analysis was also required to be undertaken as per the TP regulation and other guidelines. This was not done, which renders the comparison as unsound and unreliable. Further, the example of a automated vis-a-vis manual manufacturing unit as given by the Departmental Representative is not supported by logic. The products from a handloom would be commercially different from those produced through a powerloom. For example, a hand made Sari would typically cost more as compared to a machine weaved Sari. Also, in the case of the assessee, even if one were to compare the return on assets (i.e., capital employed), the assessee would very clearly pass the arm's length test. The ratio of PBIT over capital employed in the case of the assessee is 24.99 per cent, whereas the average in the case of the comparables approved by the CIT(A) works out at 26.56 per cent. It should also be noted that this argument of the Departmental Representative of return on assets is being brought up for discussion for the first time. 5.24 The learned Departmental Representative has also drawn reference to the decision of the Delhi Bench of the Tribunal in the cas ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he Department has 'normalised' the profits of super profit making companies. 5.26 The learned counsel submitted that the turnover range selected by it is not 'arbitrary'. Further, the Departmental Representative has not defined what is 'arbitrary' for him. A turnover filter (system based filter) of ₹ 100-250 crores (that the Departmental Representative claims to be relevant in the instant case) if used now will give an initial set of around 20 companies only. At the time of doing the TP study, the companies in the database under the heading 'software industry' gave an initial set of 402 companies. Various filters were applied on these 402 companies to arrive at the final set of comparables, one among them being the turnover filter of ₹ 5 to 250 crores. In this regard, it may be noted that Nasscom classifies companies tier-wise, based on the sales revenue of the companies. For this purpose, NASSCOM classifies companies as Tier 1 if the turnover of the company is below USD 100 million (approx. ₹ 1 to ₹ 400 crores). Further, Capitaline Plus database classifies software companies having a turnover in the range of ₹ 1 to S ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... al Representative's computation argument of a range of +/(-) 60 per cent from the turnover of the assessee is not factually correct. At the lower end, the TPO has reduced 33 per cent and at the higher end, the TPO has increased 66 per cent for arriving at his filters. This itself shows the arbitrariness in the procedure of the TPO. Without prejudice to the submission that there should be no variation in the turnover filter applied by the assessee, even based on the upper turnover filter of 66 per cent applied by the TPO, if the same percentage is applied on the lower turnover filter, the turnover range would workout to ₹ 60 crores to ₹ 240 crores. The TPO had not disclosed his search process to the assessee. Having asserted that the TPO had not disclosed his search process to the assessee, the Departmental Representative ought to have pointed out, where the disclosure was made. The reference made by the Departmental Representative to the decision of E-Gain Communication to support the turnover filter of the TPO is incomplete and erroneous. The Departmental Representative has deliberately quoted the decision selectively. In the said decision, the Tribunal has immedia ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ng the exchange rate of USD 1 = Rs. 48.27, which is the average of rates as on 1st April, 2002 and 31st March, 2003 (source: www.oanda.com) The TPO in the assessment made for asst. yr. 2002-03 has herself used an industry benchmark of USD 18-25 per hour. If the industry rates are considered as a potential CUP, the man-hour rate of the assessee and the consequent value of the international transactions of the assessee with its AE would be at arm's length. The Departmental Representative has completely missed the context while comparing the R D work of the assessee and that of M/s Visualsoft. The assessee is an R D service provider and has provided these services to its clients. The R D work carried out by the assessee is a service to its AE for which the assessee is remunerated on a cost plus basis. The assessee does not have any R D expenditure, on the other hand, M/s Visualsoft has conducted R D for itself, and the R D outflow is an R D expense for M/s Visualsoft. In the above context, it would be relevant to note that in the case of Mentor Graphics, the Tribunal has held the need for eliminating differences on account of R D expenditure. The observations of the Tribunal have ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... At para 35 of the said order, the Tribunal has observed that: In the first place, while screening and filtering of comparables, he took into account companies which were dealing with their related companies either as subsidiaries or as parent companies. Thus, controlled transactions were taken into account which is against the very basics of the transfer pricing guidelines. The above view is also supported by the OECD. In the draft notes on comparability issued by the OECD, it has been observed as follows: The working party discussed these issues and concluded that controlled transactions should by no means be used as the basis for a transfer pricing adjustment... Considering the above, the learned counsel had submitted that the companies which have been a single rupee transaction with AEs should not be considered as a comparable company. This issue has also been acknowledged by the CIT(A) and at p. 48 of her order, she has observed as below: With due respect of the Hon'ble Tribunal, I would also submit that while in a perfect world, comparables should be taken that have no related party transactions, in practice, finding such comparables appears to be bordering on the realm o ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tative/TPO, they seek shelter under practical reasons for tweaking the law to suit their convenience. Further, the reference drawn by the Departmental Representative to various other sections [such as s. 40A(2)(b) and s. 92A(2)(a)] to justify the selection of 25 per cent as the cut-off is misplaced. In fact, as submitted above, the provisions of r. 10A(a) clearly prove that where the legislature intended to give a cut-off they had provided the same in the relevant section itself. Had the legislature intended to provide any such cut-off for the purpose of eliminating companies with related party transactions, they would have provided the same in the statute itself. Instead, the legislature has clearly provided under r. 10A that companies with related party transactions cannot be considered as 'comparables.' As submitted earlier, the assessee had followed a methodical search process in the TP study. Had the data been available at the time of conducting the TP study, the assessee concedes that the two companies would have got rejected. This is not the appropriate stage to remove these two companies. 5.29 Rule 10B(1)(c)(iii)/(e)(iii) provides that the margins of the comparable ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t is the principal function of the entities. The analysis of comparison should consider total 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 com parables 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 r ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... above by way of an example, if two manufacturing companies are considered (i) ABC Ltd. which is a captive contract manufacturer supplying corrugated boxes only to its parent company in USA, namely ABC Inc. and (ii) XYZ Ltd. which is an independent company supplying identical corrugated boxes only to ABC Inc. (i.e., ABC Inc. is an independent client for XYZ Ltd.). Apart from this difference, both ABC Ltd. and XYZ Ltd. operate identically with respect to the following: (a) Both supply their products only to one customer. (b) Both have a fully automated manufacturing facility. (c) Both source their raw materials from the same vendor. (d) Both have the same number of workers with the same skill sets. (e) Both have the same volume (i.e., sales) during a year. (f) Both enjoy the same tax benefits. After considering all aspects of the business of ABC Ltd. and XYZ Ltd., it would be anybody's guess that the risk of ABC Ltd. would be less than that of XYZ Ltd. It can be no one's case that when a person would render services to a single customer, he would charge a premium for his services. In fact, the assertion made by the Departmental Representative is not in line with any theory o ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... provider) is sufficient to demonstrate that the captive service provider is effectively insulated from all business risks and, as such, any mark up ought to be only commensurate with the captive service provider's risk taking ability, and not beyond. During the course of the hearing, the Departmental Representative referred to the commercial agreements to demonstrate that the assessee also carries on pricing risk as there is an overall cap on the fee the assessee can charge to the assessee. 5.32 The learned counsel on the argument of the learned Departmental Representative pointed out it is incorrect as it is based on an ignorant interpretation of the said agreements. This can be clearly established as below: (a) Clause 1(a) of the agreement at p. 153 of the paper book very clearly provides that the invoice value will be arrived at by adding a 10 per cent margin to the total cost for a particular month. (b) Clause 2(a) of the agreement at p. 153 of the paper book only documents that on a realistic estimate, the fee to be charged for the assignment would be Euro 25,000. The said clause nowhere restricts the fee that can be charged by the assessee under cl. 1 (a) of the said agre ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... cs and E-Gain Communication clearly demonstrate that there are many other companies that are making net profit margins in the range of 5 to 10 per cent. In fact, the margins of the assessees in both these cases were in the range of 5 per cent to 7 per cent. The list of 25 companies is new material produced for the first time before the Tribunal. No such argument was raised during the course of assessment proceedings. The Departmental Representative has himself confessed that the data is available only in private domain. Further, though the Departmental Representative has argued that no fresh search has been conducted by the TPO, the action of producing a fresh list of 25 companies is contrary to such an argument. The companies listed include entrepreneurial companies such as Wipro, Mphasis, Subex. Further, this argument suffers from various infirmities such as the data submitted is for financial year 2004-05 whereas the current appeal is for financial year 2002-03. 5.34 The learned counsel submitted that the assessee understood that there are a significant number of other captive companies who have earned margins in the region of 5 to 10 per cent. The Departmental Representative ha ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... . The Tribunal in case of Mentor Graphics has also confirmed this proposition. Relevant extracts of the said decision are reproduced as under: 27.....It is a simple principle of economics that the greater the risk, the greater the expected return (compensation). With regard to objection raised by the Departmental Representative relating to increase of mark up from 5 per cent to 10 per cent, the learned counsel had submitted that the increase in the mark up of 5 per cent to 10 per cent was in view of the additional functions performed by the assessee. The learned counsel submitted that its bona fide action during the financial year 2002-03 to synchronise its margin with the prevailing arm's length criterion under Indian market conditions cannot, by itself, become a basis for alleging that the taxpayer had not fixed the price of international transactions at arm's length, but the same were fixed to suit the group's convenience. It should also be noted that the margins of the assessees in the case of Mentor Graphics and E-Gain Communication were also in the range of 5 per cent to 7 per cent, which was approved as being at arm's length by the Tribunals. 5.37 The referen ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ut of the final set of comparable companies [as approved by the CIT(A)], the CIT(A) has identified two companies as being companies earning super profits. The CIT(A) has 'normalised' the margins of such companies, by replacing their profit margins with the profit margins of the next highest profit making company from the set of final comparables. 5.40 Rule 10B(1)(c)(iii)/10B(1)(e)(iii) allows an adjustment to the margins of the comparable companies to take into account differences which could materially affect the amount of profit margins in the open market. The CIT(A) has acknowledged that the two companies have made super profits. As a corollary, it implies that these two companies are enjoying certain extraordinary benefits/advantage over the other companies, as a result of which these companies are earning significantly higher profit margins which no other company in the given industry earns, under ordinary circumstances. 5.41 Rule 10B(3) provides that an uncontrolled transaction shall be considered as a comparable if: (a) none of the differences between the comparable company and the controlled transaction is likely to materially affect the profit arising from such tra ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... order of 20 comparables would reveal that the margin of profit shown by Thirdware Solutions Ltd. and WTI Advanced Technology is extraordinary at 67.65 per cent and 54.72 per cent respectively. 5.44 The Departmental Representative has mentioned that the TPO has taken a liberal view by way of normalizing the margins of the companies accepted to be making 'super profits.' The claim made by the Departmental Representative is totally wrong. Despite there being no statutory provisions for normalization, the TPO has normalized the profits of these two companies, using the next highest profit earned by a company in the set of comparables. This approach followed by the TPO to normalize the super profit margins is clearly biased as this method has resulted in increasing the average or the arithmetical mean margin of the comparable companies. This method, in no way, can be said to be liberal. The assessee cannot be dependent upon a charitable whim of the TPO. The comparability analysis should be made on the basis of the provisions of law and not on an ad hoc basis. The argument of the Departmental Representative that the act of normalization offsetting for the need for risk adjustmen ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... like to highlight that the TPO had normalized the margins of super profit making companies by simply using the profit margin of the next highest profit making company. The approach of the TPO was also approved by the CIT(A). Neither the Act nor the Rules prescribe any method for normalizing super profit margins of companies. At one end, the CIT(A) has termed the depreciation adjustment made by the assessee to be too simplistic and at the other end, the CIT(A) has herself approved the TPO's process of normalizing the margins of super profit making companies, which is very simplistic. Further, it would be relevant to note that the concept of adjustment on account of different depreciation policies being followed has been approved by the Tribunal in the case of E-Gain Communication. The Departmental Representative has acknowledged the need for making an adjustment, but has not agreed to the methodology adopted by the assessee. 5.46 During the appellate proceedings before the CIT(A), considering the financial position of the assessee and the comparable companies, a request was made to the CIT(A) to allow making an adjustment on account of the difference in the working capital posit ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... to comment on a series of draft issues notes, has clearly recommended a need for making a working capital adjustment if the working capital position of the taxpayer is favourable as compared to the comparable companies. A brief computation of the working capital adjustment, as applicable to the present case and based on the comparables as approved by the CIT(A) is shown below: Computation of working capital adjustment Step 1 Net working capital for financial year 2002-03 for each of the comparables and the assessee is computed as under: (Net working capital for financial year 2002-03) 360 days = Holding period Sales for financial year 2002-03 Step 2 Net holding period is computed Net holding period = (Average holding period of com parables) - (Holding period of the assessee) Step 3 The net holding period is applied to the prima lending rate (PLR) to compute to the working capital adjustment. [Net holding period (in days)) x PLR360 days Actual workings are as under: Step 1 Holding period for comparables [all comparables approved by the CIT(A)) = 265.98 days. Holding period for the assessee = 80.42 days. (Note : None of the comparable companies have a holding period which is less th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... be considered as a risk free rate of return. During the previous year relevant to asst. yr. 2003-04, the bank rate as notified by the RBI was around 6.25 per cent. (e) Based on the above, the PLR can be considered as a normal risk bearing rate of return whereas the bank rate can be considered as the risk free rate of return. The difference between the two rates would be the return one would earn by bearing additional risks. Thus, the difference in the returns would be around 5.25 per cent (i.e. 11.50-6.25 per cent). (f) Accordingly, the ALP as determined by the CIT(A) (which is a risk bearing rate of return) would have to be adjusted by the risk premium of 5.25 per cent. As an alternative to the above, if one were to consider the rate at which banks charge credit card holders (35.40 per cent) as the risk bearing rate, the risk adjustment required would workout to 29.15 per cent. 5.48 At the first instance, the learned counsel submitted that the need for a risk adjustment has been approved by the Tribunals in the case of Mentor Graphics and E-Gain Communication. Independent of the above, the Departmental Representative ought to appreciate the conceptual difference between the PLR an ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... be the ALP, at the option of the assessee. Extract from Notes on Clauses to Finance Bill, 2002 Under the existing provisions contained in sub-s. (2) of the said s. 92C, the most appropriate method shall be applied for determination of ALP in the manner prescribed. The proviso to sub-s. (2) provides that if the application of the most appropriate method leads to determination of more than one price, the arithmetical mean of such prices shall be taken to be the ALP in relation to the international transaction. It is proposed to substitute the aforesaid proviso to sub-s. (2) so as to provide that where the most appropriate method results in more than one price, the arithmetical mean of such prices or, at the option of the assessee, a price which differs from the arithmetical mean by an amount not exceeding five per cent, of such mean may be taken to be the ALP in relation to the international transaction. It was submitted that the language of proviso to s. 92C(2) is clear and even without reference to extracts from Explanatory Memorandum to Finance Bill, 2002 and 'Notes on Clauses to Finance Bill, 2002', no different view can be formed. The only criterion for availing itself o ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... vant to note that this view has in principle been approved by the Kolkata Bench of the Tribunal in the case of Development Consultants. In the instant case, the TPO/CIT(A) has not applied the proviso to s. 92C(2) i.e., they have not allowed a standard deduction of 5 per cent from the arithmetical mean and have thus ignored a specific and mandatory provision of law. 5.51 The learned counsel had submitted that his arguments are squarely covered by the decision of the Tribunal in the case of Development Consultants. In the said case, the Tribunal, after considering all the facts and issues of that case had approved the methodology of the assessee in that case. The discussion on this matter is covered under paras 22 and 23 of the said order, which has been reproduced below: 22 The learned Authorised Representative submitted that in case of asst. yr. 2003-04, the arm's length GP/sales of the comparable companies is 28.22 per cent, which is lower than the GP/sales of DCIL for the year ended 31st March, 2003 of 61.10 per cent, indicating that DCIL has retained more than the arm's length margin at the gross level. He stated that transfer pricing legislation as provided in the IT Ac ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ipt of the order under sub-s. (3), the AO shall proceed to compute the total income of the assessee under sub-s. (3), the AO shall proceed to compute the total income of the assessee under sub-s. (4) of s. 92C having regard to the ALP determined under sub-s. (3) by the TPO. As discussed above, upon receipt of the order of the TPO, the AO would compute the total income of the assessee under sub-s. (4) of s. 92C. Relevant extract of the said sub-section is reproduced as under: (4) Where an ALP is determined by the AO under sub-s. (3), the AO may compute the total income of the assessee having regard to the ALP so determined. Based on the above, the learned counsel submitted that s. 92CA(4) requires that the total income of the assessee is to be computed 'having regard to' the ALP and not only either, based on, or in conformity with, the order passed by the TPO. Where the words 'having regard to' are used, the authorities should not mechanically consider only the factor which the statute had drawn their attention to, but consider all other reasonable aspects which could have a bearing on the matter. In this regard, as the expression 'having regard to' has not b ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... , it should be noted that on receipt of the show-cause notice from the AO on 29th March, 2006, the assessee filed submissions on 31st March, 2006 at 5 PM (being the date on which the AO passed the assessment order). Accordingly, it is a remote possibility that the AO would have perused the submissions, filed by the assessee and the income to a conclusion that the submissions were a repetition of the submissions filed with the TPO. 5.56 In relation to the second part of the question, the learned counsel submitted that the s. 92C(3) provides that the AO may proceed to determine the ALP if he is of the opinion that certain conditions have been satisfied. Relevant extracts of the said sub-section are reproduced as under: (3) Where during the course of any proceeding for the assessment of income, the AO is, on the basis of material or information or document in his possession, of the opinion that- (a) the price charged or paid in an international transaction has not been determined in accordance with sub-ss. (1) and (2); or (b) any information and document relating to an international transaction have not been kept and maintained by the assessee in accordance with the provisions contain ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ysis and applied the same to the assessee's case. This approach of the TPO/AO clearly demonstrates bias. In this connection, reference is also drawn to Circular No. 14 of 2001 issued by the CBDT, which also provides that only if such deficiency or insufficiency is found in the documentation of the assessee, the TPO/AO can conduct a scrutiny. The relevant extract of the circular has been reproduced below: Where such onus is discharged by the assessee and the data used for determining the ALP is reliable and correct, there can be no intervention by the AO. This is made clear by sub-s. (3) of s. 92C which provides that the AO may intervene only if he is, on the basis of material or information or document in his possession, of the opinion that the price charged in the international transaction has not been determined in accordance with sub-ss. (1) and (2), or information and documents relating to the international transactions have not been kept and maintained by the assessee in accordance with the provisions contained in sub-s. (1) of s. 92D and the rules made thereunder, or the information or data used in computation of the ALP is not reliable or correct... Further, even in the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the rate on 1st April, 2002 and 31st March, 2003). Further, the TPO in the assessment made for asst. yr. 2002-03 has herself used an industry benchmark of USD 18-25 per hour. If the industry rates are considered as a potential CUP, the man-hour rate of the assessee and the consequent value of the international transactions of the assessee with its AE would be at arm's length. Based on the above three additional analysis/workings, the learned counsel submitted that the international transactions of the assessee with its AE during asst. yr. 2003-04 are at arm's length. 5.60 In case of a reference being made to the TPO, the TPO passed his order under s. 92CA(3), a copy of which is forwarded to the AO. Sec. 92CA(4) (as it stood prior to the amendment made by the Finance Act, 2007) provides that upon receipt of the order of the TPO, the AO shall compute the total income of the assessee 'having regard' to the ALP determined by the TPO. (4) On receipt of the order under sub-s. (3), the AO shall proceed to compute the total income of the assessee under sub-s. (4) of s. 92C having regard to the ALP determined under sub-s. (3) by the TPO. The Finance Act, 2007, has amended s ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ssessment for asst. yr. 2002-03. 5.63 In this regard, the learned counsel submitted that the principles of res judicata, under which, amongst other reasons, unless new facts are brought on record, the conclusion arrived at during the assessment in respect of one year, cannot differ from the assessment in respect of the subsequent year. Further, various High Courts have held that when a question of law or fact is decided in the assessee's own case for an earlier year, the Tribunal will be justified in placing reliance on the earlier decision to base its conclusion, in the absence of any new material or change in circumstances or a fresh look necessitated on existing facts on a closer and more intelligent analysis. Reliance in this regard is placed by the learned counsel on the following decisions: (a) CIT vs. Velimalai Rubber Co. Ltd. (1990) 181 ITR 299 (Ker) (b) Annamalai Reddiar vs. CIT (1964) 53 ITR 601 (Ker) The learned counsel further submitted that in the context of transfer pricing, there is normally a presumption that the principle of res judicata does apply. This is clear from the proviso to r. 10D(4), which reads as below: Provided that where an international transacti ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... f software development services; Contractual terms; and Method of receiving remuneration. Accordingly, the learned counsel submitted that the principles of res judicata should apply in its case, and it is completely inappropriate on the part of the AO/TPO to have reached a different conclusion in asst. yr. 2003-04. 5.67 The arguments of the learned Departmental Representative are therefore factually incorrect. The order for asst. yr. 2003-04 was passed by the TPO and AO in March, 2006. It was only based on the conclusions reached in the proceedings of this year that the CIT subsequently revised the order passed for asst. yr. 2002-03. The revision order for asst. yr. 2002-03 was passed in March, 2007. 5.68 The decision of the Tribunal, Delhi, in Mentor Graphics is the only decision which specifically deals with a captive software development service provider. However, the CIT(A) has disregarded the decision of the Tribunal. In this regard, the learned counsel provided below the commonality of the facts between the assessee and Mentor Graphics, being the assessee in the cited case. Sl. No. Mentor Graphics Philips Software (assessee) 1. Engaged in rendering captive contract software d ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he Delhi Tribunal and provided appropriate relief to the assessee, as the said decision is squarely applicable in the case of the assessee. The following table shown some of the similarities between the assessee and E-Gain Communication being the assessee in the case of E-Gain Communication: S. No. E-gain Communication Philips Software (assessee) 1. E-gain Communication is a captive company rendering software development services to its associated enterprises. (Para 31 on page 23 of the order) Engaged in rendering captive contract software development services to its associated enterprises. 2. E-gain was insulated from all business and operational risks (Para 18 on page 10 of the order) Philips Software bears nominal business and operational risks. 3. Net profit margin of E-gain Communication was 5.16% (Para 4 on page 2 of the order) Net profit margin of Philips Software is 5.91 per cent. 5.70 The learned counsel submitted that all the six peculiarities mentioned by the Departmental Representative are equally applicable in the instant case: (a) Peculiarity No. 1: The TPO has also used data for other periods for the purpose of his analysis. (b) Peculiarity No. 2: The TPO has also us ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... TPO is not in conformity with the provisions of rr. 10B(4) and 10D(4). (vi) The TPO erred in disregarding the most appropriate method adopted by the assessee in the TP study, and also in using the Prowess database. The TPO did not provide any reason for deviating from the TP study in respect of these matters. (vii) The TP study cannot be ignored by the TPO, in the absence of any deficiency or insufficiency. Further, the order passed by the TPO appears to have been passed with the intention of making a higher transfer pricing adjustment. (viii) For the purpose of comparability, companies with even a single rupee of transactions with AE cannot be considered as comparables. (ix) Adjustment needs to be made to the margins of the comparables to eliminate differences on account of different functions, assets and risks. More specifically, adjustment needs to be made for: (a) Differences in risk profile. (b) Difference in working capital position. (c) Differences in accounting policies. (x) The TPO has grossly erred in 'normalising' the profits of super profit companies. Such companies should have been excluded from the list of comparables. (xi) The proviso to s. 92C(2) of the Act ..... X X X X Extracts X X X X X X X X Extracts X X X X
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