[Citation -2008-LL-0610-3]

Citation 2008-LL-0610-3
Court ITAT
Relevant Act Income-tax
Date of Order 10/06/2008
Assessment Year 2004-05
Judgment View Judgment
Keyword Tags transactional net margin method • international transaction • software technology park • transfer pricing officer • development of software • statutory requirement • associated enterprise • foreign exchange gain • foreign exchange loss • exchange fluctuation • software development • revenue authorities • higher depreciation • interest on deposit • show-cause notice • audited accounts • operating income • export turnover • interest charge • issue in appeal • total turnover • profit on sale • annual report • profit margin • audit report
Bot Summary: The TPO, on examination of Form 3CEB i.e., the audit report filed by the taxpayer, found that the taxpayer had claimed that the transactions with its associated concern were carried at arm s length and had relied on TNMM in support of its claim as under: S.No. Representative of the taxpayer accordingly submitted that in 20 companies taken into consideration by the TPO with turnover ranging from Rs. 8.29 crore to Rs. 360.61 crore as against the turnover of Rs. 10.25 crore of the taxpayer was erroneous. The taxpayer further look objection that some companies taken as comparable had income from other sources, quite dissimilar to the income of software shown by the taxpayer. The taxpayer accordingly claimed that even from the information gathered and used by the TPO, it was evident that international transact- tion carried by the taxpayer were at arm s length, and adjustments made were without any justification. Shri Ostwal, learned representative of the taxpayer reiterated that the taxpayer was a 100 per cent EOU. It had specific customers and had supplied software to its parent company in US as per specific requirement of the US parent company. With reference to balance sheet and profit and loss account of the taxpayer, he pointed out that accounts were prepared by taxpayer on the lines accounts were prepared in America by the parent company and accordingly much higher depreciation has been claimed in the accounts. Counsel for the taxpayer that the benefit of adjustment was required to be given in working the margin of profit of the taxpayer for not undertaking any risk in the transactions involved with its parent company.

118 ITD 243 Vimal Gandhi, President: This appeal by Taxpayer E-Gain Communication Pvt. Ltd., non- resident company, is directed against order of ld. Commissioner of Income-tax (Appeals) [ CIT(A) in short], confirming addition of Rs. 1,08,62,537 on account of adjustment in arm s length price under provisions of section 92CA(3) of Act for services rendered by taxpayer to its parent company in USA. 2. assessee company is engaged in business of software product development and is 100 per cent EOU unit approved by Software Technology Park of India under STPI Scheme. It is also taken as leading provider of c u s t o m e r service and contact centre software based on integrated communication platform. taxpayer has further claimed exemption under section 10A of Income-tax Act. As per audited accounts filed by taxpayer, it has shown total export turnover of Rs. 10,25,68,917 from which it derived profit of Rs. 46,95,254. 3. Assessing Officer, after noticing details of transactions of taxpayer with its associated concerns, referred case to Transfer Pricing Officer (TPO) for computation of arm s length price as per his letter dated 5-6- 2006. TPO, on examination of Form 3CEB i.e., audit report filed by taxpayer, found that taxpayer had claimed that transactions with its associated concern were carried at arm s length and had relied on TNMM in support of its claim as under: S.No. Nature of Asstt. Year Method A.Y. 2004 Method Transaction and Amount Used 05 Amount used 1. Receipt for Software Development 118626462 TNMM 102568917 TNMM 2. Purchase of computers 193562 -do- - -do- 3. Total 102568917 4. Transfer Pricing Officer further found that taxpayer had claimed net profit margin on cost at 5.16 per cent against average profit of 16.12 per cent on similar uncontrolled transactions carried by independent concerns being, similarly computed. 5. comparable enterprises taken into account for applying Transactional Net Margin Method (TNMM) and Profit Before Income Tax (PBIT) with reference to Total Turnover (TO) and total expenses was taken at 13.29 per cent and 16.12 per cent as per chart below: Company Turnover(2003- Total PBIT/Total Sl.No. PBIT PBIT/TO Long Name 04) Expd. Expd. 1. 3i Infotech Ltd. 192.6 0.04 0.02% 195.29 0.02% 2. Amex Information Technologies Ltd. 11.92 1.59 13.34% 9.98 15.93% 3. Aviation Software Development Consultancy Ltd. 18.52 3.46 18.68% 15.45 22.39% 4. FCS Software Solutions Ltd. 67.03 7.15 10.67% 59.91 11.93% 5. Gebb Infotech Ltd. 14.05 2.73 19.43% 10.62 25.71% 6. Genesys Inter-national Corpo-ration Ltd. 21.47 1.78 8.29% 18.34 9.71% 7. Geometric Software Solutions Company Ltd. 63.67 18.73 29.42% 54.71 34.24% 8. Goldstone Technologies Ltd. 57.27 2.74 4.78% 52.54 5.22% 9. Larsen & Tourbo Infotech Ltd. 364.61 9.51 2.61% 350.88 2.71% 10. Lifetree conver-gence Ltd. 12.87 0.32 2.49% 12.47 2.57% Sl.No. Company Turnover(2003- PBIT PBIT/TO Total PBIT/Total Expd. Long Name 04) Expd. 11. Pentasalt Techno-logies Ltd. 100.9 5.25 5.20% 96.45 -5.44% 12. Prithy Information Solutions Ltd. 246.77 18.03 7.31% 228.38 7.89% 13. Sasken Communication Technology 166.13 15.42 9.28 148.73 10.37% 14. Sonata Software Ltd. 69.68 12.48 17.91% 73.4 17.00% 15. Tata Elxsi Ltd. 153.48 19.71 12.84% 134.18 14.69% 16. Thirdware Solution Ltd. 23.88 10.06 42.13% 14.87 67.65% 17. Visual Soft Technologies Ltd. 153.86 39.3 25.54% 119.18 32.98% 18. VJIL Consulting Ltd. 16.06 0.36 2.24% 15 2.40% 19. WTI Advanced Technology Ltd. 8.29 4.29 51.75% 7.84 54.72% 20. Zenith Infotech Ltd. 18.28 1 5.47% 17.71 5.65% Average 13.29% 16.12% 6. In light of above detail, Transfer Pricing Officer wanted to make adjustment and, therefore, issued show-cause notice to taxpayer. reply of taxpayer is noted by TPO as under. (a)E-Gain US pays to taxpayer assured income. Therefore, taxpayer has kept cost plus 5 per cent mark as consideration for transfer to its parent company. (b)The taxpayer has earned handsome GP of 31.92 per cent on sales. (c)Taxpayer s operations constitute only 11.26 per cent of US AEs business. 7. Assessing Officer was of view that above points raised by t h e taxpayer did not answer low margin of profit charged by it from its associated concern. In fact, taxpayer had itself revised upward markup in subsequent years in its dealings with parent company. TPO, therefore, made adjustment of Rs. 1,08,62,537 after considering benefits of margin of 5 per cent permissible under proviso to section 92C of Income-tax Act with following calculations: P&L A/c as Remark P&L as per Remark per taxpayer ALP Principle Sales to 10,25,68,917 11,34,31,454 D=B+C AE Sales to Nil Nil Non-AE Margin on 5.16% 16.12% Cost Profit/Loss 50,45,654 1,57,46,771 B=C*A Total Constant 9,76,84,683 9,76,84,683 Expenses C AE 10,25,68,917 Tainted 11,34,31,454 ALP Transactions transaction- Value of trans- needs to be action adjusted +5% -5% +/-5% 11,91,03,027 10,77,59,881 analysis 8. Thus, ALP price of sale of software services by taxpayer to its AE was taken at Rs. 11,34,31,454. However, taxpayer has sold above services to its AE for Rs. 10,25,68,917 only and accordingly if -5 per cent is taken into consideration, ALP price is Rs. 10,77,59,88. Thus, taxpayer does not come within 5.1 margin and, therefore, benefit of above provision was not allowed to taxpayer. total addition was worked out at Rs. 1,08,62,537 (Rs. 11,34,31,454 - 10,25,68,917). order of TPO is very brief without much elaboration. 9. aforesaid order of Transfer Pricing Officer was adopted by Assessing Officer and assessment was made under section 143(3) of Income-tax Act. 10. taxpayer, being aggrieved, impugned order of Assessing Officer, particularly above adjustment under transfer pricing, in appeal before CIT(A). It was submitted that 263 software companies were taken into account in transfer pricing report submitted by taxpayer to TPO. After analysis, 54 companies were selected from public domain. basis of rejection of other companies through screening was also furnished to ld. CIT(A). arithmetic mean of total PBIT over income of 54 companies was worked out t 3.86 per cent against similar mean profit of taxpayer at 4.76 per cent. It was accordingly claimed that transactions by taxpayer were carried with associated concern at Arm s Length Price. 11. ld. representative of taxpayer accordingly submitted that in 20 companies taken into consideration by TPO with turnover ranging from Rs. 8.29 crore to Rs. 360.61 crore as against turnover of Rs. 10.25 crore of taxpayer was erroneous. It was accordingly submitted that companies taken into consideration by TPO were not comparable. As against above, taxpayer had worked out arithmetic mean of profit of comparable companies at 9.79 per cent which fell within margin of Arm s Length Price. 12. It was further submitted by taxpayer that data used by TPO in certain cases indicated that profit before tax (PBIT) was much more than difference between total turnover and total expenditure. This definitely indicated that those entities (companies) were having income from other sources than business of software development. taxpayer does not have any income from any other source. In this connection, attention of ld. CIT(A) was specifically drawn to profits and turnover of WTI Advanced Technology Ltd. It was accordingly contended that above company could not be taken as comparable for determining ALP. taxpayer also emphasized fact that it was entitled to exemption under section 10A of Income-tax Act and, therefore, had no motive to charge less than ALP from its associated concern. taxpayer also pointed out Ural its associated concern in USA had suffered huge losses and could not afford to pay more than cost +5 per cent benchmark for services rendered by taxpayer. 13. determination of net margin ratio with cost at average figure of 16.12 per cent of comparable entities was thus challenged on following grounds: (i)The TPO was in error in selecting comparable companies with turnover ranged from Rs. 8.29 crore to Rs. 364.61 crore while taxpayer s turnover was Rs. 10.25 crore only. Thus, basis adopted by TPO was not right. (ii)Some of selected companies had shown abnormally high profit margin and were thus not comparable. Specifically, this objection was taken in relation to comparable at Sl. Nos. 7, 14, 17 and 19 shown in TPO s report. (iii)The TPO further erroneously took into account companies showing high margin of profit of 30 per cent and more listed at Sl. Nos. 7, 16, 17 and 19 of chart referred to above. 14. taxpayer further look objection that some companies taken as comparable had income from other sources, quite dissimilar to income of software shown by taxpayer. non-business income could not be taken into account in working Arm s Length Price. 15. taxpayer after taking into account companies showing turnover ranging between Rs. 8.29 crore to Rs. 18.29 crore, out of companies taken by TPO worked out average profit of such companies at 17.83 per cent and filed details with ld. CIT(A). If item of abnormal profit i.e., at Sl. No. 19 was ignored, resultant profit would work out to only 10.45 per cent, taxpayer further claimed. 16. taxpayer accordingly claimed that even from information gathered and used by TPO, it was evident that international transact- tion carried by taxpayer were at arm s length, and, therefore, adjustments made were without any justification. 17. Ld. CIT(A), after considering relevant submission of parties and after reproducing chart and basis of adjustment of Rs. 1,08,62,537 by TPO confirmed adjustment with following observations: "2.4 I have considered submission of appellant and perused material on record. appellant has computed sale price by adding 5 per cent mark up over total expenditure. issue to be considered is whether addition of 5 per cent over total expenditure may be said to result in sale price which can be said to be at arm s length price. After taking into account normal margin in this line of business. I am of considered view - that there cannot be any doubt that assessee by keeping cost + 5 per cent mark up for determining sale price has not computed price of international transaction at arm s length. It is common place that profit in this line of business is much higher. If income in respect of companies where turnover is Rs. 5 crore to Rs. 25 crore is taken into account. PBT/TE as computed in chart 1 at page No. 3 of paper book comes to 25.52 per cent. In this regard, relevant figures are as under: Sl. Name of PBIT/TE No. Company Amex 1. Information 15.93% Technology Aviation 2. Software Dev. 22.39% Cons. Gebbs 3. 25.71% 3. 25.71% lnfotech Ltd. Genysis 4. Intern. Corpn. 9.71% Ltd. Lifetree 5. Convergence 2.57% Ltd. Thirdwave 6. 67.65% Solutions Ltd. VIGIL 7. 2.40% Consulting Ltd. WTI Advance 8. 54.72% Technologies Ltd. Zenith 9. 5.65% Infotech Ltd. 206.73% Arithmetical 22.97% mean This is much higher than what is worked out by Assessing Officer. submission of appellant that 5 per cent margin has been kept because assessee gets assured income does not answer low margin of appellant. As is noted by Assessing Officer, in fact appellant itself has upwardly revised margin in subsequent year. Be that as it may, on facts of case, it is held that Transfer Pricing Officer chose correct sample for re-computing Arm s Length Price of international transactions and adjustment of Rs. 1,08,62,537 made by Assessing Officer is in accordance with law and for justified reasons and does not call for any interference. Ground Nos. 1 to 3 of appeal are held to have no merit and they fail." 18. taxpayer, being aggrieved, has brought issue in appeal before t h e Appellate Tribunal. Shri Ostwal, learned representative of taxpayer reiterated that taxpayer was 100 per cent EOU. It had specific customers and had supplied software to its parent company in US as per specific requirement of US parent company. It was argued that taxpayer company was set up on 7-8-1999. US entity was set up two years earlier. All risk profiles under agreements were/are responsibility of parent company. Risk involved was credit risk, marketing risk, recovery risk, inventory risk, warranty risk, foreign exchange fluctuation risk or post sale risk. Shri Ostwal further stated that payment by tax payer was received by taxpayer as per agreement with parent company e-Gain Communication available at pages 1 to 8 of paper book. agreement provided for services and scope of work as under: "1. Services and scope of work: 1.1 Services: Subject to provisions of this Agreement, EC agrees to accept from ECPL & ECPL agrees to provide to EC, software development services, to design, develop, create, maintain and finetune and produce computer software or to further develop or change existing software ( Development Services ) for and on behalf of EC and which shall be defined in Statement of Work hereinafter known as Statements ) issued to and accepted by ECPL. In performing its obligations under this Agreement. ECPL shall undertake Development Services in India and on customer site on need basis. 1.2 Scope of Work: scope of work shall be outlined in each Statement s may be agreed between parties hereto from time to time. ECPL will provide adequate staff to complete development services specified in Agreement." 19. supply made to parent company represented total turnover of taxpayer. Shri Ostwal further submitted that for computation of ALP both taxpayer and TPO accept applicability for Transactional Net Margin Method (TNMM). With reference to balance sheet and profit and loss account of taxpayer, he pointed out that accounts were prepared by taxpayer on lines accounts were prepared in America by parent company and accordingly much higher depreciation has been claimed in accounts. He pointed out difference in rates of depreciation as claimed in account and as provided in Schedule XIV of Indian Companies Act. same is as under: Asset Estimated Rates Rates Life Years of as per Depreciation Schedule XIV Office 5 19 4.75 Equipment Computers 3 31.67 16.21 Furniture 5 19 6.33 & Fixtures 20. However, in light of statutory requirement of provisions of Indian Companies Act, accounts are to be prepared and depreciation claimed as per Schedule XIV of Companies Act. After taking correct depreciation as above, total operating profit works out to Rs. 82,46,869 and total operating cost at Rs. 94,378,716. PLI i.e., operating profit with operating cost works out at 8.74 per cent. adjusted figures are available at page 73 of Paper book which are as under: Statement of computation of revised operating profit margins on operating cost of assessee: E-gain Communication Private Ltd. Particulars (In rupees) e-gain communications Pvt. Ltd. Profit before Tax (A) 3,072,810 Less:- - - Other Income - Dividend - Interest 94,184 Lease rent - Profit on sale of investment - Prior period income - Foreign Exchange Gain - Sub Total (B) 94,184 Scrap sales - Miscellaneous - Profit on sale of assets - Insurance Claims received - Deferred revenue expenses - Sub Total (C) - Sub Total (D) = (B+C) 94,184 Add: Interest Expenses 10,568 Loss on sale of Investments - Foreign Exchange loss (net) 1,962,276 Sub Total (E) 1,972,844 Extraordinary and non- recurring expenses Loss and sale/disposal of 0 asset Definition in value of current 0 assets (In rupees) e- Particulars gain communications Pvt. Ltd. Misc. exp. written off 0 Adjustment accelerated 3,295,399 depreciation Referred Revenue exp. written - off Loss on inventories - Sub Total (F) 3,295,399 Sub Total (G) = (E+F) 5,268,243 Operating Profit/ Adjusted 8,246,869 PBIT (11=A-D+G) Operating Cost/ Adjusted Cost Total Cost as per P & L 99,646,959 Less:- Expenses Adjustments 5,268,243 (as per G above) Total Operating Cost 94,378,716 PLI (adjusted operating 8.74% Profit/Adjusted total operating cost) 21. Shri Ostwal did not refer to or draw our attention to transfer pricing study furnished by taxpayer but contended that even from working of TPO, it can be shown that taxpayer had carried transaction with its associated concern at arm s length. Certain transactions on well-accepted principles are to be ignored. principles applicable in this case, according to Shri Ostwal are as under: (1)That loss making companies were liable to be ignored for comparison as taxpayer was captive company. This is provided even in OECD guidelines. (2)Companies having income from other sources like interest and dividend, which have nothing to do with business of software development, are also to be ignored. At any rate, even Indian statutory regulation provided that while making caparison, adjustments are to be made for differences in entities. According to Shri Ostwal, interest or divided or income from mutual fund was income which has required to be excluded through suitable adjustments to make data used by TPO as reliable and dependable. In this connection, Shri Ostwal drew our attention to following specific entities taken by TPO for comparison. (i)Thirdware Solutions Ltd. which had shown PBIT of 67.65 per cent. Copy o f profit and loss account of above company collected from public domain with its annual report is available in paper book. profit and loss account is available at page 201 of paper book. On examination of above accounts, it i s seen on receipt side, under head Sales and other income taxpayer has shown other income at Rs. 1,41,55,687. detail given as per Schedule 13 is as under: "Schedule 13: Other Income Interest on Deposit 2,953,027 Interest on Bank 7,600,902 Deposit Debtors written back Other Income Profit on sale of 1,180,188 investment Excess provision 183,400 w/back Interest on IT Refund 394,838 Deposit W/Back-Recd. 40,000 Dividend Income 4,163,708 14,155,687" 22. Schedule XIV of balance sheet further shows that above company was in trading of software in relevant period. It was purchasing licenses and clearing them. Purchase and sale of license is not business which can at all be compared with software business. balance sheet further makes it clear that company has paid wealth tax advance and was not involved in development of technology. It did not have any income from development of software but had income from mutual funds. 23. second company required to be excluded is WTI Advance Technologies Ltd. showing PBIT of 54.72 per cent. It had income from other sources at Rs. 3,83,12,091. detail of other income as per Schedule 10 of balance sheet is as under: Schedule 10: Other Income Year ended March 31, 2004 (Rs.) Interest on deposits etc. (Gross)* (including Rs. 4,372,164 relating to 20,371,756 prior year) Profit on sale of 15,051,337 investments - Non-trade Dividend income from 1,681,240 Non-trade investments Liabilities no longer 1,067,814 required written back Miscellaneous Income 139,944 38,312,091 24. above chart showed gross income from interest, profit on investment, dividend and other miscellaneous sources of income. If profit from other sources is excluded, then profit would be less than Rs. 60 lakh. 25. third company which required adjustment was Zenith Infotech Ltd. margin profit for that company as per correct calculation would work out to 2.98 per cent as against 5.65 per cent taken by TPO. Effect on profit margin of companies after excluding non-business items (not relating to business of software) of above companies is as under: STATEMENT OF COMPUTATION OF REVISED OPERATING PROFIT MARGINS ON OPERATING COST (IN MILLIONS INR) Particulars Geometric WIT Zenith Thirdware Software Advanced Infotech Ltd. Solutions Ltd. Solutions Technologies Company Ltd. Ltd. Profit before 187.391 42.916 10.668 102.052 Tax (a) Less: Other Income Dividend 44.884 1.681 4.164 Interest 17.574 20.372 5.609 10.949 Lease Rent 13.727 Profit on sale 5.292 15.051 of investment Foreign 16.158 Exchange Gain Sub Total (B) 97.634 37.104 5.609 15.112 Miscellaneous 0.097 1.208 0.150 0.223 Sub Total (C) 0.097 1.208 0.150 0.223 Sub Total (D) 97.731 38.312 5.760 15.336 = (B+C) Add: 0.002 0.085 Interest Expense Loss on sale 1.180 of Investments Foreign 0.011 3.020 Exchange Loss (net) Sub Total (E) 0.000 0.014 0.000 4.285 Extraordinary and non-recurring expense Loss on 0.215 0.380 0.712609 sale/disposal of asset Deferred 0.073 Revenue exp. written off Loss of inventories Sub Total (F) 0.215 0.000 0.380 0.785 Sub Total (G) 0.215 0.014 0.380 5.071 = (E+F) Particulars Geometric WIT Zenith Thirdware Software Advanced Infotech Ltd. Solutions Ltd. Solutions Technologies Company Ltd. Ltd. Operating 89.874 4.618 5.288 91.787 Profit/Adjusted PBIT (II = A-D+G) Operating Cost/Adjusted Cost Total cost as per 547.062 78.258 177.860 150.929 P&L Less: Expense 0.215 0.014 0.380 5.071 Adjustments (as per G above) Total Operating Cost 546.848 78.244 177.481 145.859 PLI (Adjusted 16.43% 5.90% 2.98% 62.93% operating Profit/Adjusted total operating cost) PLI as calculated by 34.24% 54.72% 5.65% 67.65% TPO Difference -17.81% - -2.67% -4.72% 48.82% 26. Shri Ostwal further submitted that if Thirdware Solution Ltd. were excluded from comparison as it was carrying on very different functions and had different sources of income, adjusted operating profit margin of 19 companies taken into account by CIT(A) would be 10.60 per cent (mean) as per working available at page 76 of paper book which is as under: Sl..No. Name of Operating Adjusted company Profit Margins Operating Profit Marging 1. 3i Infotech 0.02% 0.02% Ltd. 2. Amex 15.93% 15.93% Information Technologies Ltd. 3. Aviation 22.39% 22.39% Software Consultancy Ltd. 4. FCS 11.93% 11.93% Software Solutions Ltd. 5. Gebbs 25.71% 25.71% Infotech Ltd. 6. Genesys 9.71% 9.71% International Corporation Ltd. 7. Geometric 34.24% 16.43% Software Solutions Company Ltd. 8. Goldstone 5.22% 5.22% Technologies Ltd. 9. Larsen & 2.71% 2.71% Toubro Infotech Ltd. 10. Lifetree 2.57% 2.57% Convergence Ltd. 11. Pentasoft -5.44% -5.44% Technologies Ltd. Sl..No. Name of Operating Adjusted company Profit Margins Operating Profit Marging 12. Prithvi 7.89% 7.89% Information Solutions Ltd. 13. Sasken 10.37% 10.37% Communication Technologies Ltd. 14. Sonata 17% 17% Software Ltd. 15. Tata Elxsi Ltd. 14.69% 14.69% 16. Visual Soft 32.98% 32.98% Technologies Ltd. 17. VJIL 2.40% 2.40% Consulting Ltd. 18. WTI Advanced 54.72% 5.90% Technologies Ltd. 19 Zenith Infotech 5.65% 2.98% Ltd. 20. Arithmetic 16.12% 10.60% Mean If range of 5 per cent permitted under section 92C(2) is taken into account, it will work out to Rs. 10,15,09,217 as against Rs. 10,25,68,917 shown by assessee in books of account. Thus profit on sales services to associated enterprises were within 5 per cent range as per proviso to section 92C(2) of Income-tax Act and therefore claim of arm s length transaction was fully established. Calculation of above is available at page 77 of paper book and is as under: "Statement of Revised Arm s length price Range and 5 per cent Adjustment Particulars Profits and ALP as per transaction revised Values as per computation of assessee s books Operating Margin of account Sales to 102,568,917 106,851,807 AE Sales to 0 0 Non AE Adjusted 8.74% 13.22% Operating Margin on Cost Operating 8,246,869 12,473,091 Profit/Loss Total 94,378,716 94,378,716 operating expenses AE 102,568,917 106,851,807 transactions 5% adjustment to arm s length price as per proviso to section 92C(2) -5% Sales 101,509,217 value at arm s length Assessee s sales to associated enterprise are within. 5 per cent range." 27. Shri Ostwal further submitted that if Thirdware Solution Ltd. is excluded, margin of profit would work out to 8.47 per cent. It was further argued that Indian regulation on transfer pricing as contained in Rule 10B, in particular, 10B(1)(h) or OECD guidelines were not followed by ld. TPO. TPO failed to make adjustments for differences in comparable transactions. Even decision of ITAT in case of Mentor Graphics (Noida) (P.) Ltd. v. Dy. CIT [2007] 109 ITD 101 (Delhi) was not followed. In this connection, he read out paras 25, 26 and 27 of above decision. He also referred to paras 1.2 and 1.4 of OECD guidelines. TPO was also wrong in totally disregarding that taxpayer was captive company. Shri Ostwal also drew our attention to paras 1.47 and 1.48 of OECD guidelines which provide for taking range. He also emphasized that taxpayer has to show that price charged by him was at arm s length, taking into account lowest margin profit in range. Shri Ostwal contended that there was total justification for exclusion of companies referred to above as these were not companies engaged in software development business. These were software trading companies and, therefore, not comparable. In end, Shri Ostwal submitted that examined from any angle, there is hardly any justification for sustaining addition on account of adjustment made by revenue authorities. 28. Ld. DR, on other hand, submitted that profitability of taxpayer was to be seen on reality of business. In assessment year 2004-05, explanation of taxpayer before TPO was different from what was stated before ld. CIT(A). Now before ITAT, totally different explanation has been furnished. parent company has suffered losses and, therefore, services by taxpayer have been provided cost + 5 per cent was not tenable argument. agreement of taxpayer with its parent company shows that it is software development company. Page2 of agreement under title Services and scope of work , it is clearly provided that taxpayer is dealing in software. He emphasized that profit shown by similar software development companies was more than 15 per cent. Ld. DR submitted that basic onus was on t h e taxpayer to show that transacts carried with associated enterprises (AE) were arm s length transactions. ld. DR supported arm s length price determined by TPO who, according to DR, had determined ALP after discussion with taxpayer and their representative. Objections on abnormalities or extraordinary circumstances of some comparable transactions were not put before revenue authorities. After lot of screening of relevant data of software companies, 20 comparables were finally selected for ultimate analysis by TPO and by CIT(A). In making selection TPO had taken into account element of risk, loss suffered by companies and gave opportunity to assessee to show as to how profit margin of 3.86 per cent shown by taxpayer was comparable. assessee further could not point out any defect in transfer pricing analysis carried out by TPO. No reason has been furnished as to why entities having total range of Rs. 8 crore to Rs. 18 crore should be selected and taken as sacrosanct. ld. TPO has determined ALP after taking into account reliable and cogent material collected from public domain. argument advanced here and defects in comparable stated before Tribunal were not stated before Assessing Officer or ld. CIT(A). ld. D R accordingly justified adjustment made by Assessing Officer and upheld by CIT(A). 29. Shri Ostwal in rebuttal refuted argument advanced by ld. DR. It was submitted that argument relating to defects in comparable taken by TPO was specifically raised and noted by ld. CIT(A). He referred to page 3 para 2 and last para of impugned order of ld. CIT(A). He, thus, contended that similar objections were raised before ld. CIT(A) and is now being repeated here. TPO did not give any opportunity to taxpayer to raise these objections. Only nine companies were taken into consideration by ld. CIT(A) to uphold ALP determined by TPO/Assessing Officer but now above two companies should be excluded or their margin of profit suitably adjusted and if adjustments are made, average would work out to 10.95 per cent against 8.7 per cent shown by taxpayer after adjustment of depreciation. revenue authorities were also duly bound to carry functional and economic analysis for entities under comparison which they failed to do. taxpayer had submitted such analysis before Assessing Officer, TPO. Copy of same is available at page 239 of paper book. There is no evidence to support contention of revenue that 15 per cent profit is being shown by similar software companies. At any rate, law of average cannot be applied to every case. Arm s Length Price has to be determined on basis of facts and circumstances of case in light of statutory provisions. 30. Shri Ostwal also relied upon para 3.5 of OECD guidelines to support h i s argument that adjustment for depreciation on account of excessive depreciation claimed is required to be made before taking marginal profit into consideration. Besides, he relied upon provisions of Companies Act under which it is mandatory to provide for depreciation as per relevant schedule. Ultimately, Shri Ostwal contended that no new argument was taken before Tribunal and case of assessee was supported on basis of material relied upon and used by revenue authorities. He maintained that adjustment made was without any basis and was liable lo be deleted. 31. We have given careful thought to rival submissions of parties. taxpayer is captive company rendering services of software development t o its parent company. As per agreement between taxpayer and its parent company, it is to receive actual cost + 5 per cent mark up for software developed and supplies to parent company. Both parties before us accept that Transactional Net Margin Method (TNMM) is most appropriate method to determining Arm s Length Price in this case. area of difference is limited to selection of comparables adopted by TPO for working out average profit without making adjustment for differences. taxpayer has further contended that its profit be taken after adjustment of depreciation as per Chapter XIV of Indian Companies Act. Out of 20 entities, dispute is restricted to mainly two entities namely. Thirdware Solutions Ltd. and WTI Advanced Technology Ltd. reasons for exclusion of these two companies and for suitable adjustment while working, average profit margin have already been noted. Ld. DR is not correct in saying that objections raised before us were not raised before revenue authorities. objection Ural companies taken as comparable by TPO are having income from other sources than business of software development was not raised but has been noted by ld. CIT(A) in para 2.1 of impugned order. name of WTI Advanced Technology is specifically mentioned. Again in para 2.2, ld. CIT(A) has recorded taxpayer s objection that companies taken by TPO for comparison have shown abnormal results by showing very high degree of profit. companies specifically pointed out are at Sl. Nos. 7, 16, 17 and 19 of list in TPO s order. Thirdware Solution Ltd. and WTI Advanced Technology Ltd. are at Sl. Nos. 16 and 19 respectively. However, ld. CIT(A) did not consider above pertinent objection of taxpayer nor referred to calculations of average margin of profit filed before him. He look for comparison companies showing turnover between Rs. 5 crore and Rs. 25 crore and worked out average PBIT/TE at 22.52 per cent and accordingly upheld addition on account of adjustment. In light of what is observed above, objection of revenue that new pleas are being advanced here has to be rejected. We proceed to consider objection of taxpayer on merit. 32. As already noted, both parties agreed that Arm s Length Price in present case is to be computed through TNMM. Rule 10B(1)(e) provides for determination of Arm s Length Price through TNMM after taking following steps: "(e)transactional net margin method, by which (i)the net profit margin realized by enterprise from international transaction entered into with associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by enterprise or having regard to any other relevant base; (ii)the net profit margin realized by enterprise or by unrelated enterprise from comparable uncontrolled transaction or number of such transactions is computed having regard to same base; (iii)the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account differences, if any, between international transaction and comparable uncontrolled transactions or between enterprises entering into such transactions, which could materially affect amount of net profit margin in open market; (iv)the net profit margin realized by enterprise and referred to in sub- clause (i) is established to be same as net profit margin referred to in sub-clause (iii); (v)the net profit margin thus established is then taken into account to arrive at arm s length price in relation to international transaction." 33. Sub-rule (3) of rule 10B requires that difference between controlled and uncontrolled transactions is to be taken into account for dealing as under: "(3) uncontrolled transaction shall be comparable to international transaction if- (i)none of differences, if any, between transactions being compared, or between enterprises entering into such transactions are likely to materially affect price or cost charged or paid in, or profit arising from, such transactions in open market; or (ii)reasonably accurate adjustments can be made to eliminate material effects of such differences." 34. It is evident from above that while comparing transactions or enterprises (in case TNMM is applied), differences which are likely to materially affect price, cost charged or paid in, or profit in open market are to be taken into consideration with idea to make reasonable and accurate adjustment to eliminate differences having material effect. If differences are such that they cannot be subjected to evaluation, then transaction may have to be eliminated for purposes of comparison. Even rule 10B(1)(c)( iii) requires adjustment of differences between international transaction and comparable uncontrolled transactions. In case of Mentor Graphics (P.) Ltd. v. Dy. CIT, this issue has been thoroughly discussed and it has been laid down that even while applying TNMM, suitable adjustment for difference on account of FAR and other relevant factor is to made. In that decision, Bench also look into account OECD guidelines on application of TNMM method and observed as under: "36.2 In TPO s views, Transaction Net Margin Method being more tolerant to minor functional differences, there was no need to carry functional and other analysis to find difference in transactions. For this purpose, he relied upon para 7.27 of OECD report of July 1995. In our opinion, para 3.27 has been taken by TPO out of context. In Guidelines strength and weaknesses of Transaction Net Margin Method has been compared with other methods and one k point stated has been overemphasized by TPO. This is what has been stated in para 3.27: 3.27 One strength of 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 transactional differences than is case with pride as used in CUP Method. net margins also may be more tolerant to some functional differences between controlled and uncontrolled transactions than gross profit margins. Differences in functions performed between enterprises are often reflected in variations in operating expenses Consequently, enterprises may have wide range of gross profit margins but still earn broadly similar levels of net profits. 36.3 Extracts from other Paras 3.29, 3.34, 3.35, 3.37 and 3.39 of same guidelines would clearly show that inference drawn is one-sided. These paras are as under: 3.29 There are also number of weaknesses to transactional net margin method. Perhaps greatest weakness is that net margin of taxpayer can be influenced by some factors that either do not have effect, or have less substantial or direct effect, on price or gross margins. These aspects make accurate and reliable determinations of arm s length net margins difficult. Thus, it is important to provide some detailed guidance on establishing comparability for transactional net margin method, us set forth in sub-section (c)(1) below. 3.34 Prices are likely to be affected by differences in products, and gross margins are likely to be affected by differences in functions, but operating profits are less adversely affected by such differences. As with resale price and cost plus methods that transactional net margin method resembles, this, however, does not mean that mere similarity of functions between two enterprises will necessarily lead to reliable comparisons. Assuming similar functions can he isolated from among wide range of functions that enterprises may exercise, in order to apply method, profit margins related to such functions may still not be automatically comparable where for instance, enterprises concerned carry on those functions in different economic sectors or markets with different levels of profitability. When comparable uncontrolled transactions being used are those of independent enterprise, high degree of similarity is required in number of aspects of associated enterprise and independent enterprise involved in transactions in order for controlled transactions to be comparable; there are various factors other than products and functions that can significantly influence net margins. 3.35 use of net margins can potentially introduce greater element of volatility into determination of transfer prices for two reasons. First, net margins can be influenced by some factors that do not have effect (or have less substantial or direct effect) on gross margins and prices because of potential for variation of operating expenses across enterprises. Second, net margins can be influenced by some of same factors, such as competitive position, that can influence price and gross margins, but effect of these factors may not be as readily eliminated. In traditional transaction methods, effect of these factors may be eliminated as natural consequence of insisting upon greater product and function similarity. 3.37 Assume, for example that taxpayer sells top quality video cassette records to associated enterprise, and only profit information available on comparable business activities is on generic medium quality VCR sales. Assume that top quality VCR market is growing in its sales, has high entry barrier, has small number of competitors, and is with wide possibilities for product differentiation. All of differences are likely to have material effect on profitability of examined activities and compared activities, and in such case would require adjustment. As with other methods, reliability of necessary adjustments will affect reliability of analysis. It should be noted that even if two enterprises are in exactly same industry, profitability may differ depending on their market shares, competitive positions, etc. 3.39 transactional net margin method may afford practical solution to otherwise insoluble transfer pricing problems if it is used sensibly and with appropriate adjustments to account for differences of type referred to above. transactional net margin method should not be used unless net margins are determined from uncontrolled transactions of same taxpayer in comparable circumstances or, where comparable uncontrolled transactions are those of independent enterprise, differences between associated enterprises and independent enterprises that have material effect on net margin being used are adequately taken into account. Many countries are concerned that safeguards established for traditional transaction methods may be overlooked in applying transactional net margin method. Thus where differences in characteristics of enterprises being compared have material effect on net margins being used, it would not be appropriate t o apply transactional net margin method without making adjustments for such differences. extent and reliability of those adjustments will affect relative reliability of analysis under transactional net margin method. 37. It is clear that even when TNMM method is applied to determine arm s length price as per OECD guidelines, functional profile, assets, assumed risks of controlled and uncontrolled transaction are to be seen while screening. Besides, it is not possible to ignore specific Indian regulations on subject. We have already noted relevant sub-rules (2) and (3) of rule 10B of Income-tax Rules, which specifically require to consider for comparison functions performed assets employed ... and risks assumed by respective parties . In Rule 10(B)(1)(c) of Income-tax Rules providing for determination through TNMM, it is clearly provided in clause (iii) net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account difference if any . These regulations have force of law and notwithstanding OECD guidelines, TPO cannot refuse to consider specific characteristics of transaction, functions performed and assets employed as has been done in this case. Total disregard of regulations non-application of filters as above has resulted in faulty selection of comparison. All sizes of companies have been selected, only commonality being their dealings in softwares. We are unable to hold and approve approach of TPO as correct." 35. We further find that provisions on transfer pricing in US also provide for "adjustment" for differences while applying method similar to TNMM. method is described as comparable profit method . Para 1.482-5 of Internal Revenue Service, Treasury is as under: "(2) Comparability - (i ) In general. degree of comparability between uncontrolled taxpayer and tested party is determined by applying provisions of 1.482-1(d)(2). comparable profits method compares profitability of tested party, measured by profit level indicator (generally based on operating profit), to profitability of uncontrolled taxpayers in similar circumstances. As with all methods that rely on external market benchmarks, greater degree of comparability between tested party and uncontrolled taxpayer, more reliable will he results derived from application of this method. determination of decree of comparability between tested party and uncontrolled taxpayer depends upon all relevant facts and circumstances, including relevant lines of business, product or service markets involved, asset composition employed (including nature and quantity of tangible assets, intangible assets and working capital), size and scope of operations, and, stage in business or product cycle. (iii) Other comparability factors. Other factors listed in para 1.482-1(d)(3) also may be particularly relevant under comparable profits method. Because operating profit usually is less sensitive than gross profit to product differences, reliability under comparable profits method is not as dependent on product similarity as resale price or cost plus method. However, reliability of profitability measures based on operating profit may be adversely affected by factors that have less effect on results under comparable uncontrolled price, resale price and cost plus methods. For example, operating profit may be affected by varying, cost structures (as reflected, for example, in age of plant and equipment), differences in business experience (such as whether business is in start-up phase or is mature), or differences in management efficiency (as indicated, for example, by objective evidence such as expanding or contracting sales or executive compensation over time). Accordingly, if material differences in these factors are identified based on objective evidence, reliability of analysis may be affect. (iv) Adjustments for differences between tested party and uncontrolled taxpayers. If there are differences between tested party and uncontrolled comparable that would materially affect profits determined under relevant profit level indicator, adjustments should be made according to comparability provisions of 1.482-1(d)(2). In some cases, assets of uncontrolled comparable may need to be adjusted to achieve greater comparability between tested party and uncontrolled comparable. In such cases, uncontrolled comparable s operating income attributable to those assets must also be adjusted before computing profit level indicator in order to reflect income and expenses attributable to income, and expense attributable to adjusted assets. In certain cases, if may also be appropriate to adjust operating profit of tested party and comparable parties. For example. where there are material differences in accounts payable among comparable parties and tested party, it will generally be appropriate to adjust operating profit of each party by increasing it to reflect imputed interest charge on each party s accounts payable. As another example, it may be appropriate to adjust operating profit of party to account for material differences in utilization of or accounting for stock-based compensation [as defined by 1.482-7(d)(2)( i)] among tested party and comparable parties." 36. It is thus evident from above that both OECD guidelines and US regulations insist on necessary adjustments for difference on issues affecting profitability. transactional net margin method may afford practical solution to otherwise insoluble transfer pricing problems if it is used sensibly and with appropriate adjustments to account for differences of type referred to above. Similarities and dissimilarities of transactions under comparison are to be scrutinized to see differences of situations, circumstances and environment. Any difference which materially affects market value is to be given serious consideration. degree of comparability between tested party and uncontrolled taxpayer with parameters like nature or line of business, product or service market, assets composition employed, size and scope of operation, stage of business or product cycle are required to be seen. In case of uncontrolled entity, operative income attributable to assets other than assets under consideration is to be adjusted before taking transaction for working mean margin of profit. Income and expenses of segment of total business may have to be considered. Depending on facts and circumstances of case, It may also be appropriate to adjust operative profit of tested party and comparable parties . But when we examine orders of revenue authorities, we do not find that comparable or tested panics were scrutinized to find differences, which needed adjustments. We may not agree with taxpayer that only entities having turnover between Rs. 8 to Rs. 18 crore were to be selected for comparison. But we see no justification for considering oversized companies as taken by TPO. ld. CIT(A) was justified in taking entities having turnover between Rs. 5 crore to Rs. 25 crore but he was in error in considering turnover as only relevant factor needed to be considered for proper analysis. What about large number of other factors which materially affect profit? functions performed, assets employed, risk taken (FAR) analysis was also required to be undertaken as per Transfer Pricing regulation and other guidelines. This was not done, which renders comparison as unsound and unreliable. When taxpayer s ld. representative had specifically pointed out that companies at Sl. No. 16 to 19, namely, Thirdware Solution Ltd. and WTI Advanced Technology Ltd. were showing extraordinary results and had income from sources other than business of software development, ld. CIT(A) did not care to examine above contention or to verify grievances raised by taxpayer but confirmed adjustments made. In these circumstances, we are inclined to hold that approach and order ld. CIT(A) was legally incorrect and order impugned before us cannot be upheld without material changes. 37. cursory look at chart in assessment order of 20 compatibles would reveal that 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. Therefore, it was necessary for tax authorities to examine whether these entities have rightly been taken as comparables for application of Most Appropriate Method. 38. Para 1.47 of OECD guidelines is to following effect: "1.47 Where application of one or more methods produces range of figures, substantial deviation among points in that range may indicate that data used in establishing some of points may not be as reliable as data used to establish other points in range or that deviation may result from features of comparable data that require adjustments. In such cases, further analysis of those points may be necessary to evaluate their suitability for inclusion in any arm s length range." 39. aforesaid guidelines lay down same principles as are reflected i n relevant Rule 10D quoted above. If there are material differences, then those differences are to be considered and suitable adjustment made. revenue authorities were in error in not making those adjustments. Now, Mr. Otswal has placed before us clinching evidence to show that above two companies had income from other sources like interest on deposit, dividend income and income from sale of licenses, which jacked up profit margin of these companies. By no stretch of imagination, above type of income could be included for purposes of comparison whereas tested party was carrying business of software development, if it was not possible to work out and exclude receipts and expenditure of above category of incomes, not relating to software development, then these companies could not be taken as comparable companies. ld. CIT(A) did not offer any comment. We are not in position to reject contention of Mr. Ostwal that these companies were trading in software and were giving licenses for use of software. Thus, line of business of these companies was different from business of taxpayer involved exclusively in development of software for its parent company. On facts and material on record, we are of view that above two companies were required to be excluded. ld. counsel has filed results of comparable companies after excluding above companies. ld. DR during course of hearing or ld. CIT(A) in impugned order did not find any defect in working furnished by assessee. As per working given, profit margin of taxpayer is quite comparable with average profit margin taken into account by revenue other than two companies mentioned above. Therefore, in our opinion, there is no justification for making addition or adjustment for arm s length price shown by taxpayer. 40. We further agree with contention of ld. counsel for taxpayer that benefit of adjustment was required to be given in working margin of profit of taxpayer for not undertaking any risk in transactions involved with its parent company. However, evaluation of above risk in present case is not necessary as even otherwise margin of profit shown by taxpayer has fully satisfied arm s length price benchmark. 41. learned DR had also raised some objection to revised margin o f profit shown by taxpayer by taking lower rate of depreciation. This objection, in our opinion, is without any substance. depreciation is required to be worked out under Indian Companies Act and, as provided in Schedule thereto. Depreciation cannot be computed as per American rules applicable to parent company. Therefore, Mr. Ostwal was correct in adjusting margin of profit of taxpayer. 42. In light of above discussion, addition on account of adjustment in Arm s Length Price is deleted. No other point was argued before us during hearing of appeal. 43. In result, appeal of assessee is allowed. *** E-GAIN COMMUNICATION (P) LTD. v. INCOME TAX OFFICER
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