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TMI Blog2015 (1) TMI 870X X X X Extracts X X X X X X X X Extracts X X X X ..... Group taking into consideration the risk adjustment envisaged by TPO for the AY 2006-07 and submitted that both 12A and 12B would make losses at net level if the risk adjusted pricing model, as proposed by the TPO were put in actual practice. Thus the risk adjusted business model as proposed by the TPO would result in an absurd situation from 12A / 12B’s perspectives defeating the concept of stable positive return for a low risk tested party. TPO totally erred in making transfer pricing adjustments in the case of assessee in both the AYs. - Decided in favour of assessee. Disallowance of software expenses - Held that:- The application software, being the subject matter of appeal, assist the already set-up business vide enhancing its efficiency and hence can be reliably related to being on revenue account. List of software purchased are enclosed in assessee’s paper book for AYs 2005-06 & AY 2006-07. On perusal of the same, we find that the parties from whom the software was acquired were Interwoven, Mercury Interactive (Singapore) Pvt. Limited, Sonata Information Technology and Tata Consultancy Services. All these companies specialize in application software which helps in increa ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of the case the Ld. CIT(A) erred in adjudicating that risk factors involved in contracts - direct and through subsidiaries are same, though it is higher in the former type and is thus entitled to larger share of proceeds. 2. That on the facts circumstances of the case the Ld. CIT(A), by deleting the transfer pricing adjustment of ₹ 62588125/-, failed to appreciate that arms length pricing adjustment was not arbitrary but is a bench mark determined on similar instances. 3. That on the facts circumstances of the case the Ld. CIT(A) erred in opening that shifting of profits is not a possibility as assessee enjoys tax benefits in India as in terms of provisions of section 92C(4), adjustment can be made in ALP even if assessee enjoys tax benefits. 4. Facts relating to above issue are that the assessee, i.e. ITC Infotech india Limited (hereinafter referred to as the assessee ), entered into international transactions with its Associated Enterprises (hereinafter referred to as AEs ). The assessee with the marketing support of its AEs is engaged in the business of Information Technology services. It undertakes customized software solution development, IT facilities man ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... er Book for AY 2005-06 AY 2006-07 respectively. He explained that customers based on their individual preferences and requirements, chooses to enter into contract with I2A/12B or directly with assessee which does not make any essential variation in sharing of functions and risks between the assessee or its AEs. He then referred to the Master Service Agreement ( in short MSA ) between the assessee and its AEs. According to him the assessee entered into separate MSA with its AEs for defining the sharing of functions and responsibilities between the assessee and its AEs, as well revenue sharing model. As per the executed MSA, services to be rendered by parties (the assessee and its AEs) have been summarised by assessee in its written submissions, which are as below:- Administrative Services Administrative services refer to customer account management and other administrative activities to be performed by the subsidiaries pursuant to the customer contract. The detailed nature of the administrative functions to be performed is provided in the MSA. Non-administrative services The non-administrative services refer to the activities and services other than the administrati ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tains 75% Respondent Performs software development services (non-administrative) Pays USD 25 to 12A/12B For administrative services Retains 25% 12A/12B Performs Administrative services Pays USD 100 to 12A/12B for provision of software development services Retains 25% 12A/12B Performs administrative services Pays USD 75 to the respondent for software development services (non-administrative) Retains 75% Respondent Performs software development service A detailed explanation of the above invoicing arrangement has been enclosed at page 640 217of the assessee Paper Book for AY 2005-06 and AY 2006-07 respectively. The same is being explained by assessee in its written submissions, which is being reproduced as under:- Model 1: Agreements executed between the respondent and the overseas customers Overseas customers with large and offshore centric (India based) engagements more often than not prefer to enter into agreements with the delivery arm of the ITC Infotech Group and accordingly enter into service contracts with the respondent. In such cases, the respondent retains 75% of the revenue ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... as under:- Sl No. AEs Description of the international transactions Amount paid/payable Amount received/receivable 1 12A Export of Software Services 36,754,764 Account management charges 37,736,909 2 12B Export of Software Services 364,592,691 Account management charges 111,186,022 For the AY 2006-07 as under:- Sl No. AEs Description of the international transactions Amount paid/payable Amount received/receivable 1 12A Export of Software Services 39,636,005 Account management charges 48,846,535 2 12B Export of Software Services ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... to back Agreement between the assessee and 12B. 9. Similarly for AY 2006-07, the TPO undertook same exercise and assessee explained the invoicing arrangements with the AEs, the roles and responsibilities of the assessee as well as of AEs and Global Delivery Model followed. However, the TPO issued show cause notice as to why transfer pricing adjustment may not be made in respect of international transactions wherein the assessee enters into contract with customers directly and pays 25% revenue share as Account Management Charges to 12A or 12B. The assessee made detailed submissions of entire business arrangement in assessee s group, demonstrating sufficient explanation that as per terms of inter-company agreements between the assessee and its AEs and also the actual conduct of business between them, there is no differences in either functions performed or risks assumed by transacting parties (namely, the assessee and 12A or 12B, as the case may be) irrespective of the invoicing model due to which no transfer pricing adjustment is warranted. The assessee explained that in the course of contract negotiation and mapping the scope of work, the customer is fully aware of the underly ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the assessee filed appeals for both AYs before CIT (A). After considering submissions made by the assessee, CIT (A) found merit in the facts of the assessee. The CIT(A) considered economic substance underlying the assessee s global business model including sharing of the functions and risks and deleted adjustments made by AO based on the order of the TPO. He observed as under:- I have considered the transfer pricing documentation maintained by the appellant, the appellant s submission and the rebuttal of the Remand Report by the Appellant and the observations and the Remand Report of the TPO. After perusing the above, I hold that: The appellant, in compliance with the law, prepared and maintained the TP Report for computing the arm s length price of its international transactions. As embodied in the TP Report, the appellant has adopted the Cost Plus Method as the most appropriate method to establish the arm s length price of the relevant transactions undertaken by the appellant with 12A and 12B while selecting 12A and 12B as the tested party . From the facts and documents presented before me, I find that the appellant s business arrangement with its foreign subsidiar ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ntities responsible for failure of delivery / nonperformance of the contract and thu9s in cases of such direct dealings, 12A and 12B bear greater risk as compared to the other model where the customers enter into contracts directly with the appellant. In my view, this logic is flawed. The determinant factor is not whether the customers can hold 12A or 12B responsible for failure of performance, but whether, as per the functional, asset and risk profiles of the three entities, namely the appellant, 12A and 12B, if 123A and 12B do not have the necessary confidence and functional strength to bear such risks, and thereby the risk should be awarded to such party under an arm s length dealing. In my view, base upon the documents submitted by the appellant and the arguments put forward before me, under either of the two situations, the functional, asset and risk profiles of 12A and 12B remain the same and the major risks relatable to bad debt and delivery failure / nonperformance, always remain with the appellant, irrespective of the two business models. I find that the TPO had in-principle accepted the remuneration model of 25% revenue sharing in case where the customers enter into contr ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 25% of the sales proceeds similar to what they are entitled to do in case where they bear the entire risk (in case of contracts directly with customer). He also highlighted that in clause 4A(iii) of the Master Agreement between the respondent and 12A, dealing with the provision of administrative services to the respondent by 12A, mentions that: If 13L (the respondent) subcontracts its obligation in accordance with these clause, the parties agree that the provisions of clause 5(iii) to (v) inclusive shall not apply and that a fee equal to 25% of the revenue derived from the customer contact shall be paid by 13L (the respondent) to IINFOTECH US. TPO contended that it is evident that if 12A subcontracts its obligations to the assessee, 12A will have to discharge all the administrative functions including those mentioned in clause 5(iii) to 5 (v), however if the assessee subcontracts its obligations to 12A, the above mentioned functions would not be discharged by 12A. However since in both the scenario, 12A is entitled to 25% of the sales proceeds, he believed that this prima-facie is not an arm s length transaction. While re-computing the Account Management charges paid by the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ather than 25% rate as provided in the Master Agreement. Based on the above, transfer pricing adjustment was computed by the TPO as follows: Adjustment in arm s length price - 12B Account management charges paid during the year by the Respondent Rs.11,186,022 Less: Arm's length price as discussed above [Rs.11,11,86,022 15/25] ₹ 66,711,613 Adjustment to the ALP ₹ 44,474,408 Adjustment in arm s length price - 12A Account management charges paid during the year by the respondent ₹ 37,736,909 Less: Arm's length price as discussed above [Rs. 3,77,36,909 13/25] ₹ 66,711,613 Adjustment to the ALP ₹ 18,113,717 Similarly, the transfer pricing adjustments made by the TPO in AY 2006-07 were as follows: Adjustment in arm s length price - 12B Account management charges paid during the year by the respondent ₹ 10,45,61,028 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 75% of the revenue, while 12B has performed the marketing and account management services and has earned 25% of the revenue. 12. According to ld. counsel, the CIT(A) referred documents to the TPO and he vide remand report No. DIT(IT)/Kol/Misc/10-11/24 dated 2nd June 2010 filed before the CIT (A), held that in cases where foreign subsidiaries enter into contact with customers, risk for execution of contract lied solely with foreign subsidiaries and that contention of the assessee that risk lies with it was held to be unsustainable by TPO. Similarly for AY 2006-07 also the assessee filed detailed submission summarising international transactions which were subject to adjustments along with facts and circumstances. After considering submissions and arguments put forth by the assessee for both the AYs, the CIT (A) found merit in the facts and granted relief deleting the entire transfer pricing adjustment for both the AYs. 13. We noted from factual aspects of the case that the TPO perceived that functional and risk profile of the assessee and its AEs are different in both the business models wherein the assessee assumes larger share of risks when contracts are entered by it wit ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... financial or technical capabilities hardly influence the decision of the customer to sign the agreement with the AEs. The assessee stated that the possibility of a customer raising any claim for deficiency in administrative services are very remote, as they are rendered to the assessee as an internal arrangement and the customers are not affected by it. Only possibility of any customer raising a claim would be in respect of non-administrative services which are exclusively provided by the assessee irrespective of the business model. It was also emphasised that it is the assessee, which has adequate capital and technical expertise to bear the risks arising from deficiency in services, which neither 12A nor 12B possess. Thus even if a customer raises any claim on 12A/12B, such risk would be eventually passed on to the assessee. 14. There is contractual relationship among the assessee, its subsidiaries and third parties. The subsidiaries, based on agreement entered into with the assessee, engage in marketing of the IT service capabilities of the assessee in their respective countries and try to win contract for providing IT services. Once a customer is identified, the subsidiaries ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the contractual arrangements (emphasis added) Furthermore, in relation to contractual relationship and conduct of the contracting parties, para 5.3.2.30 states that: The conduct of the contracting parties is generally a result of the terms of the contract between them. The contractual relationship thu9s warrants careful analysis when computing the transfer price. Other than a written contract, the terms of the transactions may be found in correspondence and communications between the parties involved. In cases where the terms of the arrangement between the two parties are not explicitly defined, the contractual terms have to be deduced from their economic relationship and conduct. (emphasis added) It is also pertinent to mention at this juncture that the concept of business risk in transfer pricing context has been discussed at length in the recent amendments to the OECD Transfer Pricing Guidelines 2010 (hereinafter referred to as OECD Guidelines ) under the new Chapter IX (Transfer Pricing Aspects of Business Restructuring). As per this new guidance, para 9.10 provides that: Risks are of critical importance in the context of business restructurings. An examinat ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ompany to have people - employees or directors - who have the authority to, and effectively do, perform these control functions. Thus, when one party bears a risk, the fact that it hires another party to administer and monitor the risk on a day-to-day basis is not sufficient to transfer the risk to that other party. Further, the OECD Guidelines have also discussed on the issue of risk allocation and financial capacity in para 9.29 9.30 as follows: Another relevant, although not determinative factor that can assist in the determination of whether a risk allocation in a controlled transaction is one which would have been agreed between independent parties in comparable circumstances is whether the riskbarer has, at the time when risk is allocated to it, the financial capacity to assume (i.e to take on) the risk. Where risk is contractually assigned to a party (hereafter the transferee) that does not have, at the time when the contract is entered into, the financial capacity to assume it, e.g. because it is anticipated that it will not have the capacity to bear the consequences of the risk should it materialise and that it also does not put in place a mechanism to cove ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... for any deficiency in non-administrative services - The Ld. TPO, vide his order, has acknowledged the fact that the MSA very clearly envisage that the subsidiaries would sub-contract to the respondent the non-administrative services and the provider of these non-administrative services, i.e., the respondent would be fully liable to the user, i.e., customer for the same. He further submitted that it has the adequate capital and the technical expertise to bear the risk that may arise for any deficiency in the services provided to the customers. The subsidiaries do not have adequate capital or technical expertise to bear such a risk. Thus, in our view, under the Business Model 2, as per terms of the MSA, in case a Customer raises any claim for non-performance of the non-administrative services, the subsidiaries would eventually pass on such risk to the assessee and the assessee has to bear such risk. The customers enter into contract with either the assessee or the subsidiaries for providing software development services. The contracts entered with customers also mention the expected standard of services to be provided for software development work. It is the internal arrangeme ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ion. In case of the assessee, there is an inherent transfer of risk by 12A / 12B to the assessee vide the MSA in relation to cases where the customer contacts directly with these. AEs and there are financial claims relating to the quality of deliverables. Such a transfer of risk through contractual arrangement is a common risk management practice in commercial world and should be duly recognized. The TPO made adjustment by determining a different revenue split [15% or 13% as the case may be] from the one followed by the respondent and 12A / 12B. Such an adjustment made by the TPO was without any basis or analysis. In relation to difference in clauses in the MSA between the assessee and 12A as referred to by the TPO for making an ad-hoc adjustment, the assessee further drew our attention towards Clauses 4A (iii) and clause 4B (ii) of the MSA which provides for the same effect in relation to exclusion of certain administrative services to be performed, Clause 4B (ii) provides that: if INFOTECH US subcontracts its obligation in accordance with this clause 4(B), the parties agree that the provisions of clause 5(iii) to (v) inclusive shall not apply and that a fee equal to 75% of th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the assessee incurred expenditure in connection with the purchase of software. The assessee is engaged in the business of software development and this software was acquired by it in connection with client projects. The software acquired was application software. During assessment proceedings also the assessee asked as to why such software expenses should not be treated as capital expenditure and it explained to AO in detail about the software acquired and the business necessity of such software. It was explained that the software acquired were application software which were being used by the assessee for its business of developing software for it clients and did not result in any enduring benefit. Even now before us also it was explained that the expenditure on purchase of software represented application software exclusively used for the purpose of the business and hence these were treated as revenue expenses in line with the principles enunciated in section 37(1) of the Act. These application software, have got a limited useful life and are used as tools of business like any other component or consumable item used for the purpose of earning revenue though application in the pro ..... X X X X Extracts X X X X X X X X Extracts X X X X
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