9911796707
TMI Blog2008 (4) TMI 340X X X X Extracts X X X X X X X X Extracts X X X X ..... n Rs. 63,37,510/- Aggregating to Rs. 1,29,13,290 together with arithmetical mistake in disallowance to the extent of Rs. 4,08,181 and thereby total disallowance sustained was Rs. 1,33,21,471/-(Rs. 1,29,13,290 + 4,08,181). 2. For that on the fact and circumstances the ld. CIT(A) wrongly and arbitrarily disallowed payment of Rs. 67,77.210/- to the approved gratuity fund. 3. (a) That on the facts and in the circumstances of the case, the ld. CIT(A) erred in confirming the adjustments of Rs. 8,44,78,673/- to the international transactions of the appellant with its Associated Enterprises (AE), namely Development Consultant International Ltd. (Bahamas). The Kulijan Corporation (USA) and Datacore Systems Inc. (USA), without considering the written submissions and the financial of the Associated Enterprises explaining the facts of the case preferred before the ld. CIT(A). (b) That on the facts and in the circumstances of the case, the ld. CIT(A) erred in holding in principle that 'No matter which method is adopted, if the facts are in order, we should arrive at the same amount of adjustment', which cannot be achieved with the various prescribed methods. 4. Without prejud ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... , even assuming but not admitting the ld. CTT(A) erred in not considering the fact that the maximum amount of adjustment to the price of international transaction of the appellant would be limited to the gross profit earned by Development Consultant International Ltd., Bahamas and accordingly should have restricted the amount of adjustment in the international transaction of the appellant with Development Consultant International Ltd., Bahamas to USD 1,74,086 i.e. INR 78,33,870/-. 4. (a) That on the facts and in circumstances of the case, the ld. CIT(A) erred in specifying the reason for confirming the adjustment to the price of international transaction between Kulijan Corporation USA and the appellant by way of a speaking order. (b) Without prejudice to ground (2) above, in the event Your Honours are of the view that ld. CIT(A) was right in confirming the adjustment, even assuming but not admitting, the ld. CIT(A) erred in not considering the fact that the maximum amount of adjustment to the price (if international transaction of the appellant would be limited to the gross profit earned by The Kulijan Corporation, USA and accordingly should have, restricted the adjustment in ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... or the assessee has disputed such addition and has admitted that this is a continuous practice of assessee and has claimed the gratuity payment on the basis of calculation and following the consistency of making provision and claiming the same in its return of income and, therefore, the action of ld. CIT(A) in enhancing the disallowance is most arbitrary and liable to be deleted. 11. The ld. Departmental Representative for the Revenue has relied heavily on the order of the ld. CIT(A). 12. We after hearing both the parties are of the opinion that the claim of the assessee that the claim of gratuity has been made strictly following the consistency in the earlier years needs verification and, therefore, we restore the matter back to the file of A.O. to decide the same afresh and affording reasonable opportunity to the assessee of being heard. We hold accordingly and allow the ground for statistical purpose. 13. We now take up grounds no. 3, 4 & 5 for the appeal relating to the assessment year 2003-04 and grounds no. 2, 3 & 4 for the appeal, relating to the assessment year 2004-05. since the said grounds deal with a common issue relating to additions made on account of transfer pric ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s border transaction with an AE is required to furnish a certificate in the form accountant report along with the return of income and also maintain necessary documents, which must be filed with the Revenue Officer at the time of transfer pricing assessment, as and when called for. It is found that the assessee had failed to furnish the accountant report under Section 92E of the IT Act alongwith its return of income for the assessment year 2003-04. Further, then required by the TPO, during the course of the transfer pricing assessment for the assessment year 2003-04 to substantiate the transactions with the AEs having regard to the ALP through filing of necessary documentation, the assessee had not furnished any details/explanation with the TPO. As a result of such non-compliance on the part of the assessee, the TPO virtually framed a best judgement assessment so far as transfer pricing is concerned for the assessment year 2003-04 and computed a transfer pricing adjustment of Rs. 8,44,78,673/- for the said assessment year. We have also noted that the assessee had again failed to furnish the accountant's report under Section 92B of the IT Act for the assessment year 2004-05. How ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... assessee for both the assessment years, not on the ground of non-compliance but on the ground of not being satisfied with respect to the arguments of the assessee justifying that the transactions entered into with the AEs were at arm's length. We have carefully considered the said submissions made by the learned AR and find the same to be correct, inasmuch as, the Commissioner (Appeals) did not uphold the additions on the ground of non-compliance by the assessee or furnishing of inadequate information/explanation by the assessee at the stage of the appellate proceedings, but the additions were sustained purely on merits. We also find that adequate opportunity was also given to the Revenue Officers at the time of the remand proceedings to verify the documents and other evidences filed by the assessee before the Commissioner (Appeals) and therefore it is nobody's case that while the appeals are subjudice before the Tribunal, the additions can be sustained on the ground that the lower authorities did not have a chance to verify in depth and detail, the documents and other explanations/information filed by the assessee. We therefore asked both the AR of the assessee and the lea ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e international transactions should be determined separately as the nature of transactions entered by the assessee with its AEs was different. Hence, the ALP would be determined based on the nature of services provided by the assessee for each class of transaction taking into consideration the functions performed, assets employed and the risks assumed, by the respective parties to the transactions. 4. The learned DR could not controvert the above arguments placed by Shri Rahul Mitra regarding determining the ALP of each international transaction separately by giving any strong argument. We are also of the same view that the ALP should be determined on a transaction-by-transaction basis and not on an aggregate basis as done by there TPO and sustained by the Commissioner (Appeals). 5. Before proceeding to discuss the determination of ALP on transaction by transaction basis, Shri Mitra submitted that as per Section- 92C(1) of the IT Act. the arm's length price of an international transaction is required to be determined using any of the prescribed methods, being the most appropriate method-having regard to the nature of transaction or class of transaction. However, in order to ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e intangible property or unique assets that distinguish it from potential uncontrolled comparables. 7. Based on the above discussion on 'tested party', Shri Rahul Mitra proceeded to argue the merits of the case for the international transactions entered by the assessee with each of its AE separately. 8. First in case of transactions entered by the assessee with its AE, DCIL in Bahamas, the learned AR stated that DCIL, is a wholly owned subsidiary company of the assessee in Bahamas. It is engaged in providing engineering services to its clients who are engaged in turnkey, projects at various industrial sites. The assessee has discussed and stated in the transfer pricing documentation report that DCIT is an entrepreneur company and since its inception it has created significant marketing intangibles. It utilizes these intangibles in order to generate work and enters into contract with third party customers. It assumes ail the major risks like market, price and product risks in relation to the work. The marketing efforts undertaken by DCIL over the years and the value of intangible, created cannot be measured and co-related with the costs reflected in the books of account. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ng guidelines issued by the OECD. Para 3.27 of these guidelines stated that, "One strength of the transactional net margin method is that net margins (e.g. return on assets, operating income to sales, and possibly other measures of net profit are less affected by transaction 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 gross profit margins. Differences in the functions performed between enterprises are often reflected in variations in operating expenses...." Shri Rahul Mitra also submitted that without prejudice to the above, since DCIL had incurred losses at the net level and comparing margins at the net level would involve the process of determining the veracity of operating expenses incurred by DCIL, and also since the TPO intended to apply Release Price Method and test the gross margins of DCIL. the assessee on a conservative basis computed the gross margins earned by DCIL. 18. After due consideration of all the facts, we agree with the view that gross margins of DCIL need to be compared with gross margins of comparable uncon ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... to that of DCIL i.e. a distributor of services. Hence, in order to arrive at a set of distributors whose assets employed are more akin to that of DCIL we have applied the following quantitative filters: - Net Sales: The companies for which no sales data was available were rejected; - Sales, General & Administrative (SG&A) Expenses: Companies having nil SG&A expenses were not considered as comparable companies to the tested party; - Research & Development Expenses/Sales 0%: We have rejected companies who have incurred any research and development expenses since DCIL as a distributor would not undertake any research and developmental activity; -SG&A Expenses/Sales falling outside Inter-Quatile Range: SG&A expenses/Sales ratio of a distributor represents the intensity of functions performed in order to generate sales. Hence, in order to select our appropriate set of comparable's we have rejected companies which were lying outside the inter-quartile range of SG&A expenses/Sales of the 242 comparable companies. -Net Profit 0: Companies having losses were rejected on a conservative basis. On execution of the above steps a set of 98 comparable companies were left. -The abo ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s to the tested party; - Research & Development Expenses/Sales 0%: We have rejected companies who have incurred any research and development expenses since DCIL as a distributor would not undertake any research and developmental activity: - SG&A Expenses/Sales falling outside Inter-Quartile Range: SG&A expenses/Sales ratio of a distributor represents the intensity of functions performed in order to generate sales. Hence, in order to select our appropriate set of comparables we have rejected companies which were lying outside the inter-quartile range of SG&A expenses/sales of 221 comparable companies. - Net-Profit 0: Companies having losses were rejected on a conservative basis. On execution of die above steps a set of 83 comparable companies were left. The above companies were then reviewed with respect to their business description in order to refine the search to include in the final set of comparables, only companies with functions similar to DCIL -this resulted in the exclusion of 54 companies and we were left with a comparable set of 29 companies. Companies were rejected by qualitative screening due to the following reasons: - Diversified Activities: engaged in m ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he arithmetical mean of such prices or at the option of the assessee, a price which may vary from the arithmetical mean by an amount not exceeding five per cent of such arithmetical mean". The assessee computed the arm's length price considering the 5% tolerance range. The results of such computation are given below: Sl. No. Particulars Reference Amount (in USD 1 Actual sales 940,822 2 Actual Cost of Sales 365,924 3 Actual Gross Profit (1-2) 574,898 4 GP/Sales 3/1 61.10% 5 Arm's Length GP/Sales 28.22% 6 Arm's Length Gross Profit 1*5 265,500 7 Arm's Length Cost of Sales 1-6 675,322 8 Arm's Length Cost of Sales considering 5% Range 7-*95% 641,556 9 Deficit in fees paid to the assessee by DCIL 8-2 275,632 Shri Rahul Mitra submitted that based on the above analysis, the amount of adjustment in the international transaction of the assessee with DCIL would be USD 275,632/-. In case of AY 2004-05, the arm's length GP/Sales of the comparable companies is 28.75%, which is higher than the GP/Sales of DCIL for the year ended 31 March 2004 of 25.26%, indicating that DCIL has not retained more than the arm ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... om the Reserve Bank of India. Hence, based on the facts and our findings we can conclude that DCIL is a company of substance and is performing full-fledged distribution activities. It is not a paper company established to evade taxes as argued by the Commissioner (Appeals) in his order. Hence, we do not find any justification in the arguments of the Commissioner (Appeals) 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 Commissioner (Appeals) 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 assessment year 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 AR. This amount converted to Indian rupees based on the average currency conversion rates for the relevant year comes to Rs.1 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... etailed engineering, preparation of construction specs & construction drawings, bid document preparation and bid evaluation, vendors' drawings review, inspection/quality control, project management, TKC has strength of 105 technical personnel in its Philadelphia office and another 68 in its Saudi Arabia, Jordan, Egypt and other offices. It is engaged in providing engineering services to its clients who are engaged in turnkey projects at various industrial sites for customers most of which are in Middle East. Its main area of expertise is Energy and Power Plant Engineering TKC has built up substantial experience in power plant engineering, having been responsible for over 3000 electric generating plants completed or in progress, with a total capacity exceeding 30,000 MW. 4. TKC is the entrepreneur company and has created significant marketing intangibles over the years. It uses its marketing intangibles to generate the work and assumes all the market, price and product risks. TKC carries out the work on its own, only parts of the job are subcontracted to the assessee for its convenience. Further, being an entrepreneur company, it is difficult to determine the profits of TKC wi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... howed that the arm's length GP/DICOP of comparable uncontrolled transactions entered by the assessee with third parties is 334.17% whereas the assessee has earned profitability at the gross level of 1092.45% on its international transactions with TKC. In case of AY 2004-05, the analysis should that the arm's length GP/DICOP of comparable uncontrolled transactions entered by the assessee with third parties is 478.75% whereas the assessee has earned profitability at the gross level of 1006.67% on its international transactions with TKC. This, Shri Rahul Mitra submitted clearly established that the international transaction of the assessee in respect of engineering drawing and design services with TKC are at arm's length for both the assessment years. 27. In addition to the above transactions, the assessee had entered into a transaction in nature of deputation of employees to DCIL and TKC. Shri Rahul Mitra made the following submissions: 1. During the years under consideration the assessee also sent its employees to TKC on deputation for a fee. The assessee did not undertake similar kind of transaction with other third parties. Hence, internal Cost Plus Method applied i ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... r which comparability is assessed by comparing economically significant financial data or rations. To insure comparability, companies with the following characteristics were eliminated. (i) had a ratio of research and development (R and D) expenses to sales that exceeded 3%, indicating the possible ownership of intangibles and/or significant activities not involved in pure service provision; (ii) had net fixed assets (NFA) to sales that exceeded 200% indicating that these companies did a significant amount of manufacturing or otherwise held substantial assets not used in providing services; (iii) had adverse sales of less than INR 1 crore during the time period because low sales volumes may indicate that the companies are starting up operations. Moreover, the reliability of the financial data for companies with low levels of sales can be significantly reduced because the financial data for companies with low levels of sales can be significantly reduced because the same persons are often both major shareholders and key employees, diminishing the economic distinction between profits and salaries. Selection Process Criteria No. of companies passing the criterion Explanati ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e products and services, Sales and support services, Travel related services, Warehousing and storage services. Out of the above 41 service categories the following category was chosen to find comparable companies for DCPL: CNS - Consultancy Service After selecting this service category, the 268 companies, which did not fall within these service categories, were rejected. This is shown in the table below: Qualitative analysis (Rejected) 268 To eliminate companies which have skipped the quantitative (formula based) screening. This would be based on the type of client activity. The above selection process resulted in the balance 7 companies being a refined set of comparable companies. Subsequently all loss-making companies were rejected. This led to the exclusion of 2 companies leaving us with a final set of comparable of 5 companies. This set of 5 companies represented the final set of comparable companies for DCPL. Rejection of Controlled companies - The selected set of five companies (showing a mean - OP/TC of 22.09%) was tested to determine whether any controlled companies i.e. which have foreign holding or subsidiary companies, existed. On the basis of their holding ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 6, 2004. This left as with 3,989 companies. As, we already had a set of companies from Prowess we extracted only the extra companies from capitaline Plus, data for which were not available in Prowess. This gave us a set of 1,288 companies from Capitaline Plus. Various data fields in Capitaline Plus and Prowess were selected and the ones that were relevant to our analysis were extracted for companies, which satisfied the aforesaid basis search criteria. A simple average of the raw numeric data fields was them computed, and various computation were performed thereon as well as on the raw data for individual years. Quantitative Screening Quantitative screening is a process under which comparability is assessed by comparing economically significant financial data or ratios. To insure comparability, companies with the following characteristics wee eliminated: (i) had a ratio of research and development (R and D) expenses to sales that exceeded 3% indicating the possible ownership of intangibles and/or significant activities not involved in pure service provisions; (ii) had net fixed assets (NFA) to sales that exceeded 200% indicating that these companies did a significant am ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... for the year ended 31st March 2004 indicate that the company has earned a profitability of 173.19% with DCIL and 121.09% with Kuljian on it international transactions when measured by the OP/TC criteria. This clearly establishes that the international transaction of DGPL with its associate is at anus length. 28. The ld. DR could not strongly oppose the submission made by Shri Rahul Mitra. He only asked for sustaining the adjustments made by the Commissioner (Appeals) in his order. 29. Based on the facts, and the arguments of both the ld. AR and DR and after due considerations of all facts of the case, we conclude that results of the analysis done from the Indian side by the assessee show that the international transactions entered by the assessee with TKC are at arm's length. The TPO and the Commissioner (Appeals) nor the TPO remarked against or made any objections against the analysis performed by the assessee to justify the ALP of its international transactions entered with TKC. Therefore, the Commissioner (Appeals) erred in sustaining the adjustments made by the TPO. Hence, there should not be any adjustment in respect of international transactions in nature of deputation ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... margins earned by Datacore India from this transaction are at arm's length. 31. Based on the facts and our findings, we agree with the submission made by the ld. AR regarding testing the margins of Datacore India for the international transaction entered by the assessee with Datacore US. 32. Shri Rahul Mitra submitted that, the profit margins of Datacore India were benchmarked, vide an external benchmarking exercise, which has been discussed in detail in the transfer pricing study report submitted by the assessee with the Commissioner (Appeals) who duly had forwarded all the said documents and evidences to the TPO and the Assessing Officer by way of remand proceedings, requesting for the views of the TPO and the AO through remand reports. The ld. AR submitted that the TPO and accordingly the AO had duly considered all the said documents and evidences and furnished remand reports before the Commissioner (Appeals), copies of which were filed with the paper book, and neither the Commissioner (Appeals), nor the TPO controverted the analysis done by the assessee and only suggested to retain the initial additions made by them at the time of the regular assessments. The results of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... n element of profitability on account of the marketing, efforts and risks undertaken by the service provider which may compose of the actual marketing, expenses incurred plus an appropriate-return on such expenses. This return may be considered as the gross profit (GP) mark-up on the total value adding expenses (VAE) of the service provider i.e. GP/VAE. But a captive service provider does not market its services and therefore would not see, to keep profitability on account of marketing activities. The Indian databases used to conduct the comparable search generally provide information for third party service providers. Therefore, an adjustment may be required to be made to the operating results of the comparable companies to even out the differences on account of the marketing activities. The Indian Relation, require that the arithmetic mean of a range of comparables be used to determine the arm's length price of intra-group transactions. The financial results of Date-Core India indicate that the Company has a OP/TC of 26.61% during 2004-05, which is within the +/-5% range of the arithmetic mean of the "Operating Profit/TC" ratio as envisaged in the proviso to Section 92C(2) o ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... )/sales-internal transfer-exp sales tax)] 50% was used as a cut-off criterion for all the years. The other operating income definition as per Prowess captures all income generated by a company apart from its manufacturing and trading revenues. This left us with 582 companies within the services industry. We also used the Capitaline Plus database to extract companies within the services industry. Here we started with a universe of 10,954 companies available in Capitaline Plus updated as of February 16, 2004. From these we extracted companies, which had Sales 0 in at least two out of the three financial years ending during the period April 1, 2001 and February 16, 2004. This left us with 3,989 companies. As we already had a set of companies from Prowess we extracted only the extra companies from Capitaline Plus, data for which were not available in Prowess. This gave us a set of 1,228 companies from Capitaline Plus. Various data field in Capitaline Plus and Prowess were selected and the ones that were relevant to our analysis were extracted for companies, which satisfied the aforesaid basis search criteria. A simple average of the raw numeric data fields was then computed, and vari ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... provider on the other hand, markets its services thereby incurring substantial expenses on account of such marketing and sales promotional activities. These third party service providers would therefore seek a return on account of the marketing functions and risks it undertakes. Therefore, service fee earned by third party service providers would have an element of profitability on account of the marketing efforts and risks undertaken by the service provider which may compose of the actual marketing expenses incurred plus an appropriate return on such expenses. This return may be considered as the gross profit (GP) mark-up on the total value adding expenses (VAE) of the service provider i.e. GP/YAE. But a captive service provider does not market its services and therefore would not seek to keep profitability on account of marketing activities. The Indian databases used to conduct the comparable search generally provide information for third party service providers. Therefore, an adjustment may be required to be made to the operating results of the comparable companies to even out the differences on account of the marketing activities. The final results are tabulated below: The ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... elfare 882,635 1,278,487 2,161,22 Purchase 2,199,119 2,199,119 Rates & Taxes 1,250 212,181 213,431 Travelling & Conveyance 901,947 2,092,509 2,994,456 Other expenses 5,680,948 9,003,373 14,684,321 Depreciation 860,643 573,762 1,434,405 Bank charges 32,443 71,831 104,274 Spec. Software Dev. Cost 1,249,080 1,249,080 Interest on loan 19,718 19,718 21,767,755 33,401,490 55,169,245 Operating profit (as per books of account) 7,086,908 (5,517,725.00) 1,569,183 The audited financials of Datacore India for the years ended 31st March, 2003 & 31st March, 2004 have been filed In the paper book. 33. The ld. DR could not controvert the submission made by Shri Rahul Mitra by placing any strong argument but only reiterated that the adjustments made by the Commissioner (Appeals) be sustained. 34. Based on facts and Our findings of the case, after due consideration of all the facts we conclude that the analysis undertaken by the assessee to determine the arm's length price of the international transaction with Datacore USA is correct and on the basis of the analysis it is seen that transaction undertaken by the taxpayer wi ..... X X X X Extracts X X X X X X X X Extracts X X X X
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