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TMI Blog2015 (12) TMI 769X X X X Extracts X X X X X X X X Extracts X X X X ..... opment services to the AE. 3. erred in rejection of the economic analysis conducted by the appellant and considering the unjustified fresh search conducted by the learned TPO. 4. Erred in considering the non contemporaneous data and single year data while determining the arm's length price. 5. Erred in inappropriate use of information obtained which was not available in public domain by exercising the powers under section 133(6) of the Act without adopting consistent and transparent approach. 6. Erred by applying turnover Rs. 1 crore as a comparability criterion without applying any range of turnover on upper side and consequently, selecting inappropriate companies as comparable to the appellant. 7. Erred by rejecting certain comparable companies identified by the appellant by applying inappropriate criteria of companies having diminishing revenue trend. 8. Erred in rejecting certain comparables considered by the appellant on the ground that the comparables were having different accounting year (other than March 31 or companies whose financial statements were for a period other than 12 months). 9. Erred in modifying the criteria used by appellant i.e. salary an ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... transactions pertaining to provision of software development services to the AE. 2. Erred in rejection of the economic analysis undertaken by the appellant and conducting unjustified fresh search conducted by the learned TPO. 3. Erred in considering the non contemporaneous data and single year data while determining the arm's length price. 4. Erred in inappropriate use of information obtained which was not available in public domain by exercising the powers under section 133(6) of the Act without adopting consistent and transparent approach. 5. Erred by applying inappropriate rejection criteria of diminishing revenue trend. 6. Erred by applying the rejection criteria of different accounting year (other than March 31 or companies whose financial statements were for a period other than 12 months). 7. Erred by rejecting the criteria or research and development (R&D) cost to sales ratio less than 10% applied by the appellant. 8. Erred in modifying the criteria used by appellant i.e. salary and wages cost ratio of 50% and applying 25% criteria for the same. 9. Erred in rejecting certain comparables considered by the appellant in the comparability analysis using ' ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... onsequential to the finding given by this Bench. 5. Ground No. 9 in A.Y. 2007-08 is against modifying the criteria used by appellant i.e. salary and wages cost ratio of 50% and applying 25% criteria for the same. Ground No. 12 of the assessee's appeal for A.Y. 2007-08 is against considering dissimilar companies as comparable companies to the appellant for determining the arm's length price. 6. Ground No. 13 in A.Y. 2007-08 is against selecting the companies having super normal profits as comparables to the appellant and ground No. 15 in A.Y. 2007-08 is against comparing full fledged risk bearing entities with the appellant's captive operations without making any risk adjustment for differences between the functional and risk profile of comparable companies considered as comparable vis a vis the risk profile of the appellant. 7. Similar grounds of appeal have also been raised by the appellant in A.Y. 2008-09. The ld A.O. observed that the assessee company filed its e-return of income on 29/10/2007 for A.Y. 2007-08 declaring total income of Rs. 5,61,900/- and on 31/08/2008 for A.Y. 2008-09 at Rs. 3,49,140/-. The cases were scrutinized U/s 143(3) of the Income Tax Act, 1961 (herein ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t U/s 92CA Rs. 85,74,926/- The above shortfall of Rs. 85,74,926/- is treated as transfer pricing adjustment u/s 92CA. If any filter or criteria applied by the taxpayer for search of comparables is accepted or any filter or criteria applied by the TPO is relaxed, the entire accept/reject matrix changes resulting in a new comparable set including those companies which are not taken either by the taxpayer or by the TPO in its final comparable set and which may not be finding place in this order. In essence, any disturbance in any one of the criteria of the taxpayer or the TPO results in fresh comparability analysis and the TPO should be given an opportunity if such situation arises. Based on the above detailed discussion, the arm's length price of the international transactions pertaining to providing software development services and support activities is determined at Rs. 8,81,73,131/-, instead of Rs. 7,95,98,205/- charged in its international transactions, resulting in an adjustment to the extent of Rs. 85,74,926/-." Summary of Transfer pricing adjustments Segment Arm's length Price Shown Adjustment Software Development Services Rs. 8,81,73,131/- Rs. 7,95,98 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he arithmetic mean of the Profit Level indicators is taken as the arm's length margin. (Please see Annexure B for details of computation of PLI of the comparables). Based on this, the arm's length price of the software development and support services segment rendered by the taxpayer to its AE(s) is computed as under: Arithmetic mean PLI : 26.20% Less: Working capital adjustment : (-) 0.18% Arm's length Margin : 26.38% Arm's length price: : Operating Cost Rs. 9,83,18,995/- Arm's Length Margin 26.38% of the Operating Cost Arm's Length Price (ALP) 126.38% of operating cost Rs. 12,42,55,545/- Price received vis a vis the Arms Length price: The price charged by the payer to its Associated Enterprises is compared to the Arms Length price as under: Arm's length price (ALP) @ 126.38% of operating cost Rs. 12,42,55,545/- Price received in the international transactions Rs. 11,19,31,568/- Shortfall being adjustment u/s 92CA Rs. 1,23,23,977/-. The ld TPO also observed that any disturbance of any one of the credit of the tax payer or the TPO result in comparability analysis and the TPO should be given an opportunity if s ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ing adjusted U/s 92CA had been computed at Rs. 83,25,858/-. The same was added in the income of the assessee. Similarly in A.Y. 2008-09, this ALP was calculated by the Assessing Officer after considering the direction of DRP and TPO at Rs. 12,00,08,165/- whereas the appellant had charged from AE for the international transaction at Rs. 11,19,31,568/-, therefore, the difference of Rs. 80,76,597/- was added in the income of the assessee. 9. Now the assessee before us in both the years. The ld AR for the assessee for ground No. 9 has submitted as under:- The ld TPO and consequently the ld A.O. have modified the selection criteria used by appellant i.e. salary and wages cost ratio of 50% and applied salary and wage cost criteria of 25% to reject companies having employee cost ratio of less than 25%. In this regard, the appellant, submits the following before your Honors: The appellant had applied similar filter for earlier A.Y. i.e. 2006- 07. The ld TPO during the assessment proceedings calculated the +/- 15% range from the employee cost ratio of the assessee (74.15% for A.Y. 2006-07) and accordingly selected comparable companies having employee cost to total cost ratio in the range ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... which was maximum 74.15% in A.Y. 2006-07 and accordingly selected comparables companies having employee cost to total cost ratio in the range of 59.15% to 89.15%, therefore, we allow the assessee's appeal on this ground. 12. For grounds No. 12 and 13 for A.Y. 2007-08, the ld AR for the assessee has submitted that the ld TPO and consequently the ld Assessing Officer had additionally considered the dissimilar companies as comparable to the appellant. The appellant had analysed these companies in detail and provided the detailed reasons for rejection of these companies. Sr. No. Company Name Margin as per TP Order Employee cost/Sales percentage Reason for inclusion by TPO Relevant pages of TPO/DRP order in the Appeal memo Submissions by Ideas India A-TPO's comparables rejected by IDeaS India 1 Accel Transmatic Limited ('Accel') 20.59% 37.90% The company derives its entire software services segment revenue from software development activities Page 36 (Ground no. 15) and Page 180 to 183 (TP order. Para 13.1) of the Appeal Memo I. The company fails employee cost filter -Fails to satisfy the Employee Cost Filter applied by the Appellant. Ratio of employees cost filter to sa ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the final set of comparable companies on the basis of Appellant's contention that the company is into sale of software products. - Refer page 510 of the paper book I. 3 Calestial Labs Limited ('Celestial') 55.10% 25.69% . As per information received u/s 133(6) of the Act, this company was engaged in software development services. 96.4% of the revenue is from the software development. Page 36 & 37 )Ground no. 15) and Page 183 to 202 (TP order :Para 13.4) of the Appeal Memo. I. The company fails to satisfy the employee cost filter. - Fails to satisfy the Employee Cost Filter applied by the Appellant. Ratio of employees cost filter to sales is 25.69%. (Refer page 484 of the paper book I) II. The company is cherry picked - Cherry picking of this company (not covered is search process carried out by the Appellant as well as learned TPO also). III. The company is functionally different - Functionally different (Refer page 629 to 638 of the paper book I for relevant extracts reproduced from the annual report evidencing the functional profile of the company and page No. 639 to 644 of paper book I for extracts reproduced from draft and herring prospectus filed by Celest ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... services". However, no break up of revenue from software services and software sales has been provided in the financial statements and therefore this company should not be accepted as functionally comparable. (Refer page 658 of the paper book I) - Very high turnover compared to Appellant's turnover- 183.51 crores. (Refer page 658 of the paper book I). 6 Infosys Technologie s Limited ('Infosys') 39.73% 45.84% The learned TPO has stated in the TP order that "this company is comparable selected by the tax payer in its TP document and was already discussed under the head "Analysis of comparables chosen by the taxpayer in its TP report" as above. The annual report is available for F.Y. 2006- 07. As per the AR, it is into software development and services and qualifies all the filters applied by the TPO. Thus, it is considered as a comparable". Page 40, 41 & 42 (Ground No. 15) and Page 210 (TP order: Para 13.11) of the Appeal Memo I. The company fails to satisfy the employee cost filter - Fails to satisfy the Employees Cost Filter applied by the Appellant. Ratio of employee cost filter to sales is 45.84%. (Refer page 484 of the paper book I) II. The company is functionally differ ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 5 of the paper book I) - Refer page 520 to 521 of the paper book I) 7 Ishir Infotech Limited ('Ishir') 31.12% 48.25% The learned TPO has relied upon the information received from the reply to notice u/s 133(6) of the Act and computed the employee cost ratio Page 42 (Ground no. 15) and Page 210 & 213 (TP order: Para 13.12) of the Appeal Memo. I. The company fails to satisfy the employee cost filter - Fails to satisfy the Employee Cost Filter applied by the Appellant. Ratio of employee cost filter to sales is 48.25%. II. The company is functionally different - As per the financial statements and response to the notice u/s 133(6), the company fails the employee cost filter (Rs. 2,935,065/- Rs. 7,42,09,887 = 3.96%). As per Schedule 15 of the Profit and Loss a/c for the year ended 31 March 2007, it is clearly evident that "Establishment expenses (Rs. 2,935,065) grouping contains all the employee related salary and expenses. However, we understand that the learned TPO has relied on response obtained u/s 133(6) and has also considered "Professional Fee paid" amounting to Rs. 34,109,398 while computing the employee cost ratio of the Company. (Refer page 521 & 661 to 663 of th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... iced on verification between the physical stocks and the book records were not material. However, the same have been properly dealt within the books of accounts." - Also, "Inventories" under the Schedules to the financial statements on page 15 of the annual report (Refer page 668 of the paper book I) discloses "Software development" as inventory and work-in-progress. It is to be noted that a pure software services provider would not be able to disclose such details as it does not carry any such inventory or work-in-progress. - "Background" under the Schedules to the financial statements on page 18 of the annual report (Refer page 669 of the paper book I) clearly states: "The company is engaged in development of Software and Software products since its inception. The company consisting of STPI unit engaged in Development of Software and Software Products and a Training Centre engaged in training of Software professionals on online projects." (emphasis supplied) - "Revenue recognition" under the Notes to the financial statements on page 18 (Refer page 669 of the paper book I) of the annual report clearly states:"The company derives its revenues primarily from software services and so ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... customer's separately for customization. The cost of customization is included in the cost of sale for licenses." Therefore, considering the company-wide margins on the ground that significant revenues from the XIUSBCGI division are from customization services is not appropriate. Further, if the XIUS-BCGI division )Products division) was actually similar to the Blue Ally Division (Consulting division) (as is being alleged by the learned TPO), the company would not have disclosed the two divisions as separate lines of businesses reporting is sufficient proof that these two divisions are functionally different. Considering the above, the company is functionally noncomparable on a companywide basis. If at all, the company is to be considered as comparable, the consulting division (Blue Ally division) needs to be considered for the purpose of comparability. Further, the margin computation of the aforesaid company after considering the comparable segment (consulting division) is provided on page 606 of the paper book I. 10 Persistent Systems Limited ('Persistent') 23.77% 54.95% The company qualifies all the filter applied by the TPO Page 44 and 45 (Ground No. 15) and Page 232 (TP ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... re is no sub-services break up/information provided in the annual report or the databases based on which the Appellant could compute the margin from software services activity. - Without prejudice to Appellant's contention that information obtained u/s 133(6) of the Act should not be used. Appellant submits that Tata, in its reply u/s 133(6), has itself requested the learned TPO not to use the company's data for comparison since the activities performed by the company are unique. (Refer page 528 to 530 of the paper book I). 12 Wipro Limited ('Wipro') 35.01% 42.13% As per information available u/s 133(6) of the Act, segmental details were called for and as segmental details were available for software development segment, the same is considered as comparable Page 47 & 48 (Ground no. 15) and Page 248 to 255 (TP order: Para 13.27) of the Appeal Memo I. The company fails to satisfy the employee cost filter - Fails to satisfy the Employee Cost Filter applied by the Appellant. Ratio of employee cost filter to sales is 42.13% (Refer page 484 of the paper book I). II. The company is functionally different - The company during the year has acquired Quantec Global Services LLC, Quante ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ct and technology development which is different from the functions of the Appellant. - The company has also employed 550 people in R&D activities. The R&D efforts have contributed to 8.5% of the revenues. IV. Significantly high turnover - Very Huge turnover of Rs. 961`6.09 crores as compared to the Appellant. - Refer page 531 of the paper book I. The ld AR for exclusion of 12 comparables as referred above has relied upon recent decision of the Hon'ble Delhi High Court in the case of CIT Vs. Agnity India Technologies Pvt. Ltd. in ITA No. 1204/2011 order dated 11th July, 2013 wherein large and bigger company in the area of development of software held cannot be a benchmark or equated with the small company. 13. On the other hand, the ld Sr. DR drew our attention to findings recorded by the ld TPO and also drawn our attention on ld DRP's order on page No. 21 to 33 wherein the Hon'ble DRP has considered the assessee's objection para wise and rejected the same. Therefore, she prayed to confirm the order of the Assessing Officer. 14. We have heard the rival contentions of both the parties and perused the material available on the record. It is a fact that the T ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nbsp; 11. Helios and Matheson information technologies limited 36.63% 35.17% 35.67% NC 12. Igate global solutions limited 7.49% 6.20% 69.74% 6.20% 13. Infosys Technologies limited 40.30% 39.73% 45.84% NC 14. Ishir Infotech Limited 30.12% 31.12% 48.25% NC 15. KALS information systems limited (segmental) 30.55% 24.10% 36.62% NC 16. Lucid software limited 19.37% 17.69% 41.17% NC 17. Mediasoft solutions limited 3.66% 2.14% 69.19% 2.14% 18. Megasoft limited (segmental)**** 60.23% 52.14% 37.87% NC 19. Mindtree limited 16.90% 16.00% 55.27% 16.00% 20. Persistent systems limited 24.18% 23.77% 54.95% 23.77% 21. R S software (India) limited 13.47% 13.76% 64.62% 13.76% 22. R systems international limited (segmental) 15.07% 13.87% 56.32% 13.87% 23. Sasken communication technologies limited (segmental) 22.17% 21.75% 57.03% 21.75% 24. Tata Elxsi limited (segmental) 26.51% 26.87% 54.35% 26.87% 25. Thirdware solutions Limited 25.12% 22.19% 62 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... iness parlance it is known as 'single customer risk'. * The cost plus agreement with the AE does not guarantee sufficient volume of business nor period as the agreement is for a period of one year and renewed one year at a time unless terminated otherwise. The agreement can be terminated by any party at any time after giving a stipulated period notice. Thus the taxpayer is not free from the risk of losing business entirely or losing volume of business. * the taxpayer is not compensated any amount for termination of agreement even if it is terminated without any cause. No independent enterprise would like to agree for a termination clause without compensation if it is terminated without any cause. * The AE is exposed to the market risk and any fluctuation in the business conditions of the AE affect the contractual terms between the AE and the taxpayer. Thus even if independent comparables undertake some risk, the taxpayer also had to undertake risks like single customer risk, political risk, etc. which are not incurred by the comparable companies and hence the risks are evened out. * There are many captive service providers operating in the same environment as the taxpay ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... etween the taxpayer and the comparable companies. * Different comparables can have different risk profiles and different profit margins. The proviso to Sec. 92C(2) of the Act provides for adopting arithmetical mean to the different prices. This provision neutralizes the effect of difference in the risk profile, if any between the tax payer and the comparables as realized risk may pull down the profitability below the risk free return. * It is not sufficient to merely spell out risks. But, it has to be shown which risk was actually undertaken by the comparables and to what extent it affected the profitability. The taxpayer has not done so. Finally she rejected the assessee's claim of risk adjustment and held that no risk adjustment is given as the single customer risk and country/political risk of the taxpayer combined with the arithmetic mean price considered in the case of comparable companies nullifies the risk differential, if any, between the tax payer and comparable independent enterprises. 16. The ld AR of the assessee reiterated the same argument raised before the ld TPO as well as before the ld DRP. At the outset, the ld Sr. DR. has supported the order of the TP ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... entioned in the TP order) 2. Search for comparable companies Conducted search using Prowess database updated as on 12th July 2008 and Capitaline database updated as on 6th June 2008 for identifying comparable companies Conducted unjustified fresh search using noncontemporaneous data for identifying additional comparable companies 3. Type of companies identified as comparable Indian companies engaged in providing similar services as that of the Appellant Inappropriately exercising the powers under section 133(6) of the Act and relying on the data received from the companies in response to notice u/s 133(6) of the Act for identifying companies as comparable to the Appellant. 4. Filters i) Use of Contemporaneous and Multiple year data Use of non-Contemporaneous and single year data for F.Y. 2007-08 ii) Companies having turnover less than 2 crores and more than 50 crores are to be excluded Companies whose software development income is less than 1 crore are to be excluded (without specifying any upper turnover limit) iii) Companies whose salaries and wages cost ratio is less than 50% to be excluded Companies whose salaries and wages cost ratio is less ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e learned TPO during the assessment proceedings calculated the +/- 15% range from the salaries and wages cost ratio of the assessee (74.15% for A.Y. 2006-07) and accordingly selected comparable companies having salaries and wages cost ratio in the range of 59.15% to 89.15%. In case of appellant, the salaries and wages cost ratio for current year is 63.88%. Applying the basis applied by the TPO for A.Y. 2006-07, the +/- 15% range comes to 48.88% to 78.88% which is approximately close to the salary and wage cost ratio of 50% applied by the appellant. This also gives a clear indication that it is into software development and not into software products. Therefore, to identify appropriate comparable companies engaged into software development activities, a closer filter i.e. 50% should be used in order to arrive at close comparables or filter of 48.88% to 78.88% to be considered (as applied by the learned TPO and considered by the Hon'ble ITAT in the Appellant's own case for A.Y. 2006-07). In respect of the above, the appellant wishes to place reliance on the following judicial precedents: Avaya India (P) Limited Vs. ACIT (ITA No. 5150/Del/2010) In view of the above, the follo ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... roduced in earlier para. The assessee has given reasons for not considering 7 comparables considered by the TPO. The ld AR's arguments for not considering these 7 comparables referred in Annexure-A in its submission has found logical as margin of these companies were found much more than the assessee has disclosed. The assessee also argued that these companies are dissimilar to the company of the assessee either employees cost, nature of business, functional differences etc., which was submitted before the TPO for not considering these comparables as comparable with the assessee. The TPO/DRP had not given any specific finding for not considering the assessee's explanation submitted during the course of assessment proceedings on dissimilar companies. Finally, the comparables out of 18 comparables considered by the TPO and after considering the assessee's objection for non comparable cases in case of 7 comparables, the average mean as worked out by the AR comes to 16.71%. The assessee has shown operating margin @ 13.17% resulting in difference of 3.54% which is within safe harbour rules. Since we have already held that these 7 comparables should be excluded the consequent difference ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... operations without making any risk adjustment for difference between the functional and risk profile of comparable companies. The assessee claimed various risk adjustments before the TPO such as market risk, service liability risk, credit and collection risk, man power risk, price risk, foreign exchange risk, Idle capacity risk, political risk, single customer risk and country risk, which has been considered by the TPO in her order and finally considered this issue from page No. 90 to 99 and finally concluded as under:- * As discussed above, the taxpayer has also undertaken several risks. Therefore, it is not correct to say that it is a risk mitigated entity. * 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 compensation model with the AE does not guarantee volume of business nor the period. The agreement can be terminated by any party at any time after giving a stipulated period notice. Thus the taxpayer is not free from the risk of losing business entirely or losing volume of business. * The taxpaye ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ayer. 25. The ld AR of the assessee reiterated the same argument raised before the ld TPO as well as before the ld DRP. 26. We have heard the rival contentions of both the parties and perused the material available on the record. The ld AR had not able to quantify these adjustments in terms of statistical calculation and has not been able to demonstrate the effect of these risks on adjustment of ALP. The ld TPO was right by accepting the arithmetic mean of comparable of comparable companies if any risk as claimed by the appellant was concerned, it will be resulted in the arithmetic mean of all the companies as these risks adjustments also applicable for them. These additions have been confirmed by the ITAT in the cases of Vedaris Technology (2010-TII-10-ITAT-Del-TP), M/s Marubeni India Private Ltd. (2011-TII-36-ITAT-Del-TP), M/s ADP Private Limited (201TII-44-ITATHyd- TP), M/s Symantec Software Solutions Pvt. Ltd. (2011-TII-60-ITATMum- TP), M/s ST Micro Electronics (2011-TII-63-ITAT-Del-TP), M/s Exxon Mobil company India Pvt. Ltd. (2011-TII-68-ITAT-Mum-TP) and M/s Deloitte Consulting India P Ltd. ITA No. 1082/Hyd/2010 and held that the assessee could not show how such difference i ..... 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