* IN HIGH COURT OF DELHI AT NEW DELHI Reserved on: 18.09.2019 Pronounced on: 18.05.2020 + ITA 201/2018 PRINCIPAL COMMISSIONER OF INCOME TAX-7 Appellant Through: Ms. Vibhooti Malhotra, Standing Counsel for Department of Income Tax. versus OPEN SOLUTIONS SOFTWARE SERVICES PVT. LTD. Respondent Through: Mr. Sachit Jolly, Advocate. CORAM: HON'BLE MR. JUSTICE VIPIN SANGHI HON'BLE MR. JUSTICE SANJEEV NARULA JUDGMENT SANJEEV NARULA, J. 1. By way of present appeal under Section 260A of Income Tax Act, 1961 ( Act ), Appellant (Revenue) assails order dated 17.04.2017 ( impugned order ) passed by Income Tax Appellate Tribunal ( ITAT ) in ITA No. 7078/Del/2014 for Assessment Year ( AY ) 2010-11. grievance of appellant is against exclusion of four comparables introduced by Transfer Pricing Officer ( TPO ) for benchmarking international transaction of rendition of software services by Respondent- ITA 201/2018 Page 1 of 32 assessee to its parent company -Open Solutions Inc., USA, Associated Enterprise ( AE ). Facts in brief 2. respondent-assessee is engaged in business of development of computer software and related services. It was set up in India as separate entity to specifically provide software development, research and other services to its AE. During relevant previous year, respondent had rendered services to its AE and declared its income at Rs.6,060/- and book profit of Rs.4,37,12,441/- under section 115JB of Act. price for international transactions with its AE was valued at Rs.38,40,88,682/-. assessee benchmarked aforesaid international transaction using Transactional Net Margin Method ( TNMM ) and computed Profit Level Indicator ( PLI ) of international transaction at 11.87%. assessee selected 14 comparable companies engaged in software development services and arithmetic mean of PLI was computed at 11.91%. Based on above, assessee declared that its profit margins were at arm s length price ( ALP ) when compared to similarly situated companies. 3. Assessing Officer ('AO') picked up case for scrutiny and reference was made to Transfer Pricing Officer ('TPO') under section 92CA of Act to determine ALP. TPO vide order dated 16.01.2014 rejected transfer pricing study undertaken by assessee and further undertook extensive study by applying fresh filters for benchmarking international transaction entered into by respondent- assessee and substituted its own ALP with ALP determined by ITA 201/2018 Page 2 of 32 respondent. In this exercise, TPO, inter alia introduced four comparables which are subject matter of present dispute: (i) Infosys Ltd, (ii) Wipro Technology Services Ltd., (iii) Persistent Systems Ltd. and (iv) Thirdware Solutions and Sales Ltd. By taking aforesaid comparables into consideration, TPO computed arithmetic mean of PLI of transactions entered by similarly situated 21 companies at 27.86%, and, therefore, addition of Rs. 5,49,05,106/- was proposed to total taxable income of assessee. 4. draft assessment order was passed by AO under Section 143 (3) read with Section 144C (1) of Act and total assessed income was computed at Rs. 5,76,91,078/-, by making two-fold additions to assessee s taxable income: (a) Addition on account of transfer pricing adjustment at Rs. 5,49,05,106/- ; (b) Disallowance of excess depreciation at Rs. 27,79,910. 5. Aggrieved by draft assessment order, assessee filed its objections before Dispute Resolution Panel ('DRP') with regard to inclusion of above-noted four comparables. However, DRP vide order dated 29.10.2014 partially allowed and affirmed inclusion of said comparables. Accordingly, TPO vide order dated 11.11.2014, complied with direction of DRP and revised ALP adjustment at Rs.3,59,52,769/- to income of respondent. final assessment was completed vide order dated 25.11.2014, assessing total income of respondent at Rs.3,59,58,831/- after making transfer price addition of Rs.3,59,52,769/-. ITA 201/2018 Page 3 of 32 6. Aggrieved by final assessment order, respondent preferred appeal before ITAT, inter alia assailing inclusion of aforesaid four comparables. Impugned order of Tribunal: 7. Tribunal undertook FAR analysis i.e. examination of functions performed, assets employed and risks assumed as provided under Rule 10B (2) (b) of IT Rules, and vide order dated 17.04.2017, it directed deletion of four comparables in question. As regards inclusion of Infosys Ltd, it was held that said comparable is functionally different from assessee company, since it has diversified profile which entails product conceptualization, core design, research and development, marketing, sales and post sales services, none of which is performed by assessee company. asset profile of Infosys Ltd. consists of significant brand value and intangibles. It assumes huge entrepreneurial risk, market risk, commercial risk, project liability risk, technology risk and credit risk, whereas assessee is risk mitigated captive service provider and therefore such giant company cannot be compared with assessee. Wipro Technology Services Ltd. was deleted since its transaction failed Related Party Transaction (RPT) filter. It was held that comparable had rendered services to Citi Group as part of pre-acquisition understanding, and, therefore, revenue of comparable is on account of related party transactions, making company unviable comparable . As regards Persistent Systems Ltd, Tribunal examined its Annual Report and observed that no segmental information is available, as to revenue earned ITA 201/2018 Page 4 of 32 on account of software services and on account of sale of software products and in absence of such segmental information it could not be added as comparable. Likewise, fourth comparable- Thirdware Solutions and Sales Ltd. was deleted by Tribunal since it was functionally dissimilar to assessee company and therefore, proper comparability analysis could not be carried out since assessee herein is only engaged in providing software development services. It was also observed that segmental data of products and services is not available and moreover, said comparable had been rejected in case of Finserv India Pvt Limited, group company of assessee. Question of law: 8. following question of law arises for our consideration: Whether ld. Tribunal was correct in deleting four comparable companies for purpose of assessment of arm s length price for benchmarking present assesee s international transaction? Submissions on behalf of Appellant/ Revenue 9. Ms. Vibhooti Malhotra, learned senior standing counsel for appellant/Revenue has assailed findings of ITAT for exclusion of said comparables, inter alia contending that under TNM method, greater latitude is allowed in choice of comparables. This implies that broad similarity in functions of tax-payer and comparable is sufficient for application of TNM method. She further argued that high turnover of comparable companies cannot ipso facto be criteria for excluding them, unless there is functional dissimilarity. Once comparable ITA 201/2018 Page 5 of 32 passes filters applied by TPO, and same are accepted by tax- payer-assessee, no further challenge can be made to allege functional dissimilarity between tested party (taxpayer) and comparable. Tribunal erred in deleting comparable without considering specific findings of TPO and DRP on their comparability. Ms. Malhotra filed detailed note discussing concept of TNM method viz impact of turnover, size, brand, equity and other related intangibles to explain comparability analysis done during application of said method. She relied on definition of TNMM provided in Rule 10 B (1)(e) of Income Tax Rules, which reads as under: (e) transactional net margin method, by which, (i) net profit margin realised by enterprise from international transaction [or specified domestic 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) net profit margin realised by enterprise or by unrelated enterprise from comparable uncontrolled transaction or number of such transactions is computed having regard to same base; ITA 201/2018 Page 6 of 32 (iii) 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 [or specified domestic 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) net profit margin realised 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) net profit margin thus established is then taken into account to arrive at arm's length price in relation to international transaction [or specified domestic transaction]; 10. Further elaborating her submissions, Ms. Malhotra argued that TNM method allows for comparison of net margins earned from international transaction (of tested party) and uncontrolled transaction (of comparable company) as opposed to other methods such as Comparable Uncontrolled Price (CUP), which is based on comparison of price charged; and Cost Plus Method (CPM) which is based on study of gross margins; TNM method does not require very strict functional similarity between controlled and uncontrolled transaction. Since TNM method is study of net margins, functional differences which may affect gross margins of operating expenses, will have limited effect in case of net ITA 201/2018 Page 7 of 32 margins. She further relied on OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration, 2017, which reads as under: 2.68... One strength of transactional net margin method is that net profit indicators (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 price, as used in CUP method. Net profit indicators 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, this may lead to wide range of gross profit margins but still broadly similar levels of net operating profit indicators. In addition, in some countries lack of clarity in public data with respect to classification of expenses in gross or operating profits may make it difficult to evaluate comparability of gross margins, while use of net profit indicators may avoid problem. [Emphasis Supplied] 11. Ms. Malhotra also contended that material differences between enterprises can be made subject to adjustments. TNM method, being study of net margins, is more reliable measure of transfer pricing, even though functional dissimilarity exists between comparable and tested party. Therefore, she argued that it can be seen that differences in turnover, size, brand, equity and other related intangibles of tested party and comparable is not evaluating factor once TNMM has been applied. 12. She also made elaborate submissions with respect to deletion of four comparables. As regards Infosys Ltd., she argued that only 4.38% of itsoperating revenue is earned from sale of its software product, whereas ITA 201/2018 Page 8 of 32 around 95% is earned from software development services. assessee itself had adopted approach of selecting comparables which are engaged in software development services and, therefore, Infosys is functionally similar and thereby comparable with assessee. She further contended that since expenses incurred by Infosys are primarily in relation to development of software services, difference in expenditure between assessee and comparable is not significant reason to exclude comparable. Factors such as heavy marketing expenses and recognizable brand value of comparable are not substantial factors to allow exclusion of comparable. Brand building and marketing expense constitute only 0.34% of comparable company s total revenue, which in turn, substantially increases cost factor of services rendered by comparable. These factors do not render Infosys Ltd. unsuitable for comparability. 13. deletion of Wipro Technology Services Ltd., was challenged by contending that Section 92 B (2) of Act has no applicability in present case as comparable and Citi Group are unrelated parties and therefore, transaction between them could not be held to be related party transaction. 14. She further argued that third comparable, Persistent Systems Ltd. was included by TPO after analyzing its Red Herring Prospectus and it was observed that it is predominantly engaged in outsourcing of software services, just like assessee. comparable company does sell some products, but product revenue comes out to be only 5% of total ITA 201/2018 Page 9 of 32 revenue. Therefore, company should be included in list of comparables. 15. Ms. Malhotra, further contended that fourth comparable company, Thirdware Solutions and Sales Ltd., was removed on ground of diversified operations and absence of any segmental data of revenue. TPO had included this company after observing its annual report and noting that it is software service company. Software development, implementation and support services are various sub-segments of software development services. Even other services provided by comparable, such as implementation and management services of software applications, are in realm of software services and are performed by software engineers. sale of license by comparable constitutes only 2.2% of its total sales and therefore said comparable ought not to be deleted from list of comparables. She further argued that ITAT cannot engage in cherry- picking of comparable companies and delete companies which they feel are not suitable for calculation of arm s length price, in case of assessee. In support of her submissions, Ms. Malhotra relied upon judgments of this court in Rampgreen Solutions Pvt. Ltd. v. CIT,[2015] 60 taxmann.com 355 (Delhi) and Chryscapital Investment Advisors (India) Pvt. Ltd. v DCIT,[2015] 56 taxmann.com 417. Submissions on behalf of Respondent/Assessee 16. Mr. Sachit Jolly, learned counsel for respondent/ assessee submitted that issue regarding applicability of TNMM in context of ITeS companies is no longer res integra. He also placed reliance on Rampgreen ITA 201/2018 Page 10 of 32 (supra) wherein Court held that even while applying TNM method, actual functional profile of comparable and assessee should be similar. He submitted that in comparability analysis, business environment, demand and supply of services, assets employed and competence to provide different services are factors which would have material bearing on profitability of these entities. He also argued that reasoning given in Rampgreen (supra) was followed by this court in M/s Avaya India Pvt. Ltd. V. ACIT, (2019) 416 ITR 638, wherein impact of brand value in comparability analysis of captive software service providers was examined by this Court. relevant paragraphs of said judgment are extracted herein under: 27. There is merit in contention of Assessee that scale of operations of comparables with tested entity is factor that requires to be kept in view. TCS E-Serve has turnover of Rs.1359 crores and has no segmental revenue whereas Assessee s entire segmental revenue is mere 24 crores. As observed by this Court in its decision dated 5th August 2016 in ITA 417/2016(PCIT v. Actis Global Services Private Limited) Size and Scale of TCS s operation makes it inapposite comparable vis-a-vis Petitioner. As already pointed out earlier there is closer comparison of TCS E-Serve Limited with Infosys BPO Limited with each of them employing 13,342 and 17,934 employees respectively and making Rs.37 crores and Rs.19 crores as contribution towards brand equity. When Rule 10(B) (2) is applied i.e. FAR analysis, namely, functions performed, assets owned and risks assumed is deployed then brand and high economic upscale would fall within domain of assets and this also would make both these companies as unsuitable comparables. 28. Director s report of TCS E-Serve Limited bears out contention of Assessee that both entities have been leveraging TCSs scale and large client base to increase their business in ITA 201/2018 Page 11 of 32 significant way. submission that two comparables offer illustration of "an identical transaction being conducted in uncontrolled manner overlooks effect of Tata brand on performance of impugned comparables. question was not merely whether margins earned by Tata group in providing captive service to Citi entities were at arm s length. question was whether they offered reliable basis to re-calibrate PLI of Assessee whose scale of operations was of much lower order than two impugned comparables. mere fact that transactions were identical was not, in terms of law explained in above decisions, either sole or reliable yardstick to determine apposite choice of comparables. 17. Mr. Jolly concurred with established principle of law that comparable cannot be deleted on sole ground of high turnover and supernormal profits, as held in Chryscapital (supra), however, he argued that in assessee s case, Tribunal deleted four comparables on multiple grounds. comparable - Infosys Ltd. was deleted due to presence of high brand value, size of their operations, difference in services rendered and risk profile. He also highlighted fact that said comparable has been deleted in proceedings in case of sister company of assessee- Fiserv India Ltd., for same AY 2010-2011 in ITA 602/2016. Besides, same comparable was also deleted in another case of CIT v. Agnity India technologies Pvt. Ltd., 2013 SCC OnLine Del 2521. This company also operates in same business vertical i.e. captive software development services. Both aforementioned orders have been upheld by this Court. 18. As regards to second comparable- Wipro Technology Services Limited, Mr. Jolly contended that as per pre-acquisition understanding, ITA 201/2018 Page 12 of 32 Wipro Technology Services has only rendered services to Citi Group. entire revenue of Wipro Technology Services is on account of these related party transactions and hence it fails filter of 25% RPT to sales as applied by TPO in original round of proceedings, which was also confirmed by DRP and such transaction would be tainted transaction' as per Section 92B (2) of Act. 19. In respect of deletion of Persistent Systems Private Ltd. and Thirdware Solutions and Sales Ltd., Mr. Jolly argued that said comparables are functionally dissimilar from assessee and are engaged in carrying out sales of software products, unlike assessee company. Moreover there is no separate segmental information available regarding revenues earned for separate activities conducted by comparables. He pointed out that Tribunal has rightly observed that domestic sales of Persistent Systems Pvt. Ltd. is Rs. 30.4 Crores as compared to nil of assessee and commission paid to agents on sales is calculated at Rs. 3.31 Crores, which indicates that this company derives substantial income from sales. Both Wipro Technology Services and Persistent Systems Ltd. have been deleted in case of assessee s group company in CashEdge India Pvt. Ltd, in ITA 279/16 for same AY 2010-11.Thirdware Solutions and Sales Ltd. is also engaged in sale of licenses, software services and revenues from subscription and that said comparable was deleted in case of assessee s sister company-Fiserv India, and said order was affirmed by this Court vide order dated 06.01.2016 in Pr. Commissioner of Income Tax vs. Fiserv India, ITA 17/2016. ITA 201/2018 Page 13 of 32 Analysis/Reasoning 20. We have considered rival submissions of parties. We have also carefully perused records and examined case laws cited by both parties. issues raised by appellant are in fact no longer res integra. This Court has consistently held that only those comparables which are functionally similar to assessee (tested party) and operate in similar business environment as that of assessee should be used for benchmarking to arrive at accurate calculation of arm s length price. 21. We do not agree with contention of appellant that TNMM does not require functional similarity between tested party and comparable. Section 92C (1) of Act contains provisions relating to various methods for calculation of ALP. Rule 10B of IT Rules provides for calculation/determination of ALP. Rule 10B (2) describes grounds on which comparability of international transaction (or specified domestic transaction) with uncontrolled transaction should be based on. This sub-rule reads as follows: Determination of arm s length price under section 92C 10B(2) For purposes of sub-rule (1), comparability of international transaction [or specified domestic transaction] with uncontrolled transaction shall be judged with reference to following, namely: (a) specific characteristics of property transferred or services provided in either transaction; ITA 201/2018 Page 14 of 32 (b) functions performed, taking into account assets employed or to be employed and risks assumed, by respective parties to transactions; (c) contractual terms (whether or not such terms are formal or in writing) of transactions which lay down explicitly or implicitly how responsibilities, risks and benefits are to be divided between respective parties to transactions; (d) conditions prevailing in markets in which respective parties to transactions operate, including geographical location and size of markets, laws and Government orders in force, costs of labour and capital in markets, overall economic development and level of competition and whether markets are wholesale or retail. above Rule manifests that in order to ensure correct estimation of ALP, it is critical that entities chosen as comparables are functionally similar to assessee. In Chryscapital (supra), Division Bench of this Court held that if comparable and assessee are functionally similar, then comparable cannot be excluded only on ground that it is operating on supernormal profits. comparable could nonetheless be included if material difference on account of such high profits could be eliminated. relevant portion of judgment reads as under: 39. This Court proceeds on basis that there is sufficient guidance and clarity in Rule 10B on principles applicable for determination of ALP. These include various factors to be taken into consideration, approach to be adopted (functions performed, taking into account risks borne and assets employed, size of market, nature of competition, terms of labour, employment and cost of capital, geographical location etc). extent of accurate adjustments possible, too, is factor to be considered. Rule 10B(3) then underlines what ALP determining exercise entails, if there are dissimilarities which materially affect price charged etc: first attempt has to ITA 201/2018 Page 15 of 32 be to eliminate components which so materially affect price or cost. In other words, given data available, if distorting factor can be severed and other data used, that course has to be necessarily adopted. 40. In present case, this Court holds that once Brescon, Keynote and Khandwala Securities are held to be functionally similar to assessee, they would be included as comparables, notwithstanding their high profit margins, provided that material difference on account of such high profit margins can be eliminated under Rule 10B(3) analysis. [Emphasis Supplied] 22. In Chryscapital (supra)it has also been held that while adopting TNMM, comparability of controlled international transaction with uncontrolled transaction has to be seen in light of functions performed, taking into account assets employed and risks assumed by parties, as per Rule 10 B (2). These parameters cannot and should not be relaxed even while employing method like TNMM, where compared net margins of profit may be arguably unaffected by external factors surrounding companies. determination of ALP, therefore, has to necessarily confirm to mandate of Rule 10B. characteristics of services provided, contractual terms of transaction indicating how responsibilities, risks and benefits are to be shared between parties, conditions prevailing in markets, size of geographical markets, can be some of factors in respect of which similarity and dissimilarity has to be evaluated. Court in Chryscapital (supra) further noticed clause (f) of Rule 10C(2), and held that TPO can make requisite adjustments to account for ITA 201/2018 Page 16 of 32 differences in such factors, if any. attempt should be made to eliminate components which may materially affect price. 23. Let s now take note of views of this Court in Rampgreen (supra). This Court in said case also held that further enquiry by TPO needs to be undertaken to ascertain whether such differences materially affect cost or price of service rendered by comparable and whether such differences could be reasonably adjusted. On perusal of OECD Guidelines, it was concluded that entities selected as comparable should be functionally similar and entertain similar business environment and risks as tested party. This Court held as under: 21.In order for benchmarking studies to be reliable for purposes of determining ALP, it would be essential that entities selected as comparables are functionally similar and are subject to similar business environment and risks as tested party. In order to impute ALP to controlled transaction, it would be essential to ensure that instances of uncontrolled entities/transactions selected as comparables are similar in all material aspects that have any bearing on value or profitability, as case may be, of transaction. Any factor, which has influence on PLI, would be material and it would be necessary to ensure that comparables are also equally subjected to influence of such factors as tested party. This would, obviously, include business environment; nature and functions performed by tested party and comparable entities; value addition in respect of products and services provided by parties; business model; and assets and resources employed. It cannot be disputed that functions performed by entity would have material bearing on value and profitability of entity. It is, therefore, obvious that comparables selected and tested party must be functionally similar for ascertaining reliable ALP by TNMM. Rule 10B(2) of ITA 201/2018 Page 17 of 32 Income Tax Rules, 1962 also clearly indicates that comparability of controlled transactions would be judged with reference to factors as indicated therein. Clause (a) and (b) of Rule 10B(2) expressly indicate that specific characteristics of services provided and functions performed would be factors for considering comparability of uncontrolled transactions with controlled transactions... XXXX 32. In present case, Tribunal noted that Vishal and eClerx were both engaged in rendering ITeS. Tribunal held that, "once service falls under category of ITeS, then there is no sub-classification of segment". Thus, according to Tribunal, no differentiation could be made between entities rendering ITeS. We find it difficult to accept this view as it is contrary to fundamental rationale of determining ALP by comparing controlled transactions/entities with similar uncontrolled transactions/entities. ITeS encompasses wide spectrum of services that use Information Technology based delivery. Such services could include rendering highly technical services by qualified technical personnel, involving advanced skills and knowledge, such as engineering, design and support. While, on other end of spectrum ITeS would also include voice-based call centers that render routine customer support for their clients. Clearly, characteristics of service rendered would be dissimilar. Further, both service providers cannot be considered to be functionally similar. Their business environment would be entirely different, demand and supply for services would be different, assets and capital employed would differ, competence required to operate two services would be different. Each of aforesaid factors would have material bearing on profitability of two entities. Treating said entities to be comparables only for reason that they use Information Technology for delivery of their services, would, in our opinion, be erroneous [Emphasis Supplied] ITA 201/2018 Page 18 of 32 24. Further, Court also expounded on concept of functional similarity in TNM Method in following words: 42. Before concluding, there is yet another aspect of matter that needs consideration. Tribunal proceeded on basis that while applying TNMM method, broad functionality is sufficient and it is not necessary that further effort be taken to find comparable entity rendering services of similar characteristics as tested entity. DRP held that TNMM allows flexibility and tolerance in selection of comparables, as functional dissimilarities are subsumed at net margin levels, as compared to Resale Price Method or Comparable Uncontrolled Price Method and, therefore, functional dissimilarities pointed out by Assessee did not warrant rejection of eClerx and Vishal as comparables. 43. In our view, aforesaid approach would not be apposite. Insofar as identifying comparable transactions/entities is concerned, same would not differ irrespective of transfer pricing method adopted. In other words, comparable transactions/entities must be selected on basis of similarity with controlled transaction/entity. Comparability of controlled and uncontrolled transactions has to be judged, inter alia, with reference to comparability factors as indicated under rule 10B(2) of Income Tax Rules, 1962. Comparability analysis by TNMM method may be less sensitive to certain dissimilarities between tested party and comparables. However, that cannot be consideration for diluting standards of selecting comparable transactions/entities. higher product and functional similarity would strengthen efficacy of method in ascertaining reliable ALP. Therefore, as far as possible, comparables must be selected keeping in view comparability factors as specified. Wide deviations in PLI must trigger further investigations/analysis. ITA 201/2018 Page 19 of 32 44. Consideration for transaction would reflect functions performed, significant activities undertaken, assets or resources used/consumed, risks assumed. Thus, comparison of activities undertaken/functions performed is important for determining comparability between controlled and uncontrolled transactions/entity. It would not be apposite to ignore functional dissimilarity only for reason that its impact may be reduced on account of using arithmetical mean of PLI. DRP had noted that eClerx was functionally dissimilar, but ignored same relying on assumption that functional dissimilarity would be subsumed in profit margin. As noted, content of services provided by Assessee and entities in question were not similar. In addition, there were also functional dissimilarities between Assessee and two entities in question. In our view, these comparability factors could not be ignored by Tribunal. While using TNMM, search for comparables may be broadened by including comparables offering services/products which are not entirely similar to controlled transaction/entity. However, this can be done only if (a) functions performed by tested party and selected comparable entity are similar including assets used and risks assumed; and (b) difference in services/products offered has no material bearing on profitability. [Emphasis Supplied] 25. above decision was followed in Avenue Asia Advisors Pvt. Ltd. v. DCIT, 2017 SCC OnLine Del 10650, wherein Court observed that though in TNMM method there is sufficient tolerance, mere broad functionality is by itself insufficient . relevant portion is extracted as under: 20. perusal of above decision reveals that following steps ought to be undertaken in identification of comparable transactions/entities. ITA 201/2018 Page 20 of 32 principle governing identification of comparable transactions would be same, irrespective of whichever transfer pricing method is adopted. Comparable transactions must be selected on basis of similarity with controlled transaction/entity. Rule 10B(2) of Income Tax Rules, 1962 ought to be borne in mind while choosing factors of comparability in respect of uncontrolled transactions. Even while adopting TNMM method, standard for selection of comparable transactions/entitles cannot be diluted. Wide deviation in Profit Level Indicator ( PLI ) would require further investigation/analysis. For comparison of transactions, factors such as nature of capital, resources used, risks assumed, etc. ought to be considered. 26. Again in Avaya India (supra), this Court while undertaking FAR analysis deleted TCS E-Serve Ltd. from list of comparables and observed that if comparable has much larger scale of operation compared to assessee, it would not be able to serve as reliable foundation for calculation of PLI for assessee even if transactions are said to be identical. relevant portion of said judgment is extracted herein below: 15. In large number of decisions this Court has emphasized, that for there to be reliable benchmark studies for determining ALP not only comparables have to be functionally similar but should have similar business environment and risks as tested party. detailed exposition of legal position with specific reference to Rule 10B(2) of Income Tax Rules, 1962 is found in this Court's decision in Chryscapital Investment Advisors (India) Pvt. Ltd. v. DCIT 376 ITR 183 (Del) as under: 30. reasoning adopted in various judgments noticed above, shows that functional analysis seeks to ITA 201/2018 Page 21 of 32 identify and compare economically significant activities and responsibilities undertaken, assets used and risks assumed by parties to transaction. Quantitative and qualitative filters/criteria have been used in different cases to include or exclude comparables. intuitive logic for excluding big companies from list of comparables while undertaking FAR analysis of smaller company is attractive, given that such big companies provide services to diverse clientele, perform multifarious functions, often assume risks and employ intangible assets which are specially designed, unlike in case of smaller companies. bigger companies have established reputation in segment, are well known and employ economies of scale to telling end. On other hand, these obvious - and apparent features should not blind TPO from obligation to carry out transfer pricing exercise within strict mandate of Section 92 C and Rules 10-A to 10-E. 31. Arm's length price determination, in respect of international transaction has necessarily to confirm to mandate of Rule 10B. In this case, method followed for determining arm's length price of international transaction adopted by assessee and revenue is TNMM. comparability of international transaction with uncontrolled transaction has, in such cases, to be seen with reference to functions performed, taking into account assets employed or to be employed and risks assumed by respective parties to transaction as per rule 10B(2)(b). specific characteristics of property transferred or services provided (contemplated by Rule 10B(2)(a)) in either transactions may be secondary, for judging comparability of international transaction in TNMM, because price charged or paid for property transferred or services provided and direct and indirect cost of production incurred by enterprise ITA 201/2018 Page 22 of 32 in respect of property transferred or services provided go into reckoning comparability analysis in transaction methods, i.e. comparable uncontrolled price, resale price and cost plus whereas profit based method such as transactional net margin method takes into account, net margin realised. In TNMM, comparability of international transaction with uncontrolled transaction is to be seen with reference to functions performed as provided in sub-rule (2)(b) of rule 10B read with sub-rule (1)(e) of that rule after taking into account assets employed or to be employed and risks assumed by respective parties to transaction. As noticed earlier, Rule 10B(3) mandates that given or select uncontrolled transaction selected in terms of Rule 10B(2) shall be comparable to international transaction if none of differences, if any, between compared transactions, or between enterprises entering into such transactions are likely to materially affect price or cost charged or paid or profit arising from such transaction in open market or reasonably accurate adjustment can be made to eliminate effects of such difference. XXXX 27. There is merit in contention of Assessee that scale of operations of comparables with tested entity is factor that requires to be kept in view. TCS E-Serve has turnover of Rs. 1359 crores and has no segmental revenue whereas Assessee's entire segmental revenue is mere 24 crores. As observed by this Court in its decision in Pr. CIT v. Actis Global Service (P.) Ltd. [IT Appeal No. 417 of 2016, dated 5-8-2016]"Size and Scale of TCS's operation makes it inapposite comparable vis-a- vis Petitioner." As already pointed out earlier there is closer comparison of TCS E-Serve Limited with Infosys BPO Limited with each of them employing 13,342 and 17,934 employees respectively and making Rs. 37 crores and Rs. 19 crores as contribution towards ITA 201/2018 Page 23 of 32 brand equity. When Rule 10(B) (2) is applied i.e. FAR analysis, namely, functions performed, assets owned and risks assumed is deployed then brand and high economic upscale would fall within domain of "assets" and this also would make both these companies as unsuitable comparables. 28. Director's report of TCS E-Serve Limited bears out contention of Assessee that both entities have been leveraging TCSs scale and large client base to increase their business in significant way. submission that two comparables offer illustration of "an identical transaction being conducted in uncontrolled manner" overlooks effect of Tata brand on performance of impugned comparables. question was not merely whether margins earned by Tata group in providing captive service to Citi entities were at arm's length. question was whether they offered reliable basis to re-calibrate PLI of Assessee whose scale of operations was of much lower order than two impugned comparables. mere fact that transactions were identical was not, in terms of law explained in above decisions, either sole or reliable yardstick to determine apposite choice of comparables. [Emphasis Supplied] 27. From exposition of law in Rampgreen Solutions (supra) and other judgments referred above, it is clear that even while applying TNM method, comparables cannot be picked on basis of broad classification under various heads, and that actual functional profile of comparable must be similar, if not same, to that of taxpayer-assessee. In comparability analysis, business environment; demand and supply of services; assets employed, and, competence to provide different services are factors which would have material bearing on profitability of entities and, therefore, regard must be had to such factors. In application ITA 201/2018 Page 24 of 32 of TNM method, broad similarity in domain of services is not enough and overall FAR analysis of comparable sought to be used must be similar with taxpayer-assessee. While there can be no quarrel with proposition canvassed by Ms. Malhotra that comparable cannot be excluded on ground of high turnover alone, but fundamental question before us is, whether exclusions in present case are, as matter of fact, on this ground? On perusal of impugned order passed by ITAT, we find that none of comparables have been excluded solely on ground of high turnover. primary reason for excluding four comparables in question is on account of dissimilarity in overall profile of said comparables with respondent-assessee. 28. Let us briefly evaluate reasoning of ITAT for deleting comparables. As regards first comparable-Infosys Ltd., it possesses huge tangibles of more than Rs. 1,00,000/- Crores. It is full-fledged risk bearer with turnover of more than Rs. 12,000/- Crores. functions of Infosys Ltd. are highly diversified, and branching out into product conceptualization, core design, research & development to marketing and sales of products, etc. No such function is carried out by assessee. Being captive service provider, its function is completely confined to software development services for its AE. There are no intangibles owned by assessee and it incurs no expenditure on research & development. We find that these distinguishing factors are highly substantial and cannot be ignored or severed from comparison. contractual terms of transaction will be heavily influenced by this and other factors, such as, overall economic standing of Infosys Ltd. in market, thereby affecting cost of transaction that ITA 201/2018 Page 25 of 32 it enters into. Furthermore, this comparable has been deleted in case of assessee's sister concern in Fiserv India Ltd., and same has been upheld by this Court, therefore, we are not inclined to interfere with order of deletion of Infosys Ltd. as comparable. 29. As regards second comparable- Wipro Technology Services Ltd., comparable was part of Citi Group prior to 20.01.2009 and provided services to City Group and was known as Citi Technology Services Ltd. Citi Group entered into Master Agreement with Wipro Ltd., whereby Wipro acquired 100% interest in Citi Technology Services Ltd. and comparable was renamed as Wipro Technology Services Ltd. with effect from 01.01.2009. As per Master Agreement, Wipro Technology Services Ltd. would continue to provide services such as delivery of technology, infrastructure, services and application, development and maintenance to Citi Group, which were delivered by erstwhile Citi Technology Services Ltd. main ground for exclusion of this comparable is that its entire revenue is on account of related party transactions and it fails criteria of RPT filter. critical question is whether pre-arrangement between Citi group and Wipro Limited would make subsequent rendition of services by this company to Citi Group fall within meaning of deemed international transaction as defined under section 92B(2) of Act. At this juncture, it would be apposite to reproduce Section 92B (2) of Act: Section 92B(2): transaction entered into by enterprise with person other than associated enterprise shall, for purposes of sub-section (1), be deemed to be international transaction entered into between two associated enterprises, if there exists prior agreement in relation to relevant ITA 201/2018 Page 26 of 32 transaction between such other person and associated enterprise, or terms of relevant transaction are determined in substance between such other person and associated enterprise where enterprise or associated enterprise or both of them are non-residents irrespective of whether such other person is non-resident or not. [Emphasis Supplied] 30. perusal of aforenoted provision shows that transaction between unrelated party and enterprise would be deemed to be international transaction if there was any prior agreement between parties on basis of which transaction is being undertaken. There was indeed prior agreement between Citi Group and erstwhile Citi Technology Services for rendition of software services. After acquiring Citi Technology Services (now Wipro Technology Services) by Wipro Ltd, since comparable company continues to deliver services to Citi Group, this entire transaction would be considered as related party transaction. pre-arrangement between Citi group and Wipro Ltd. is deemed international transaction as per Section 92B (2). Therefore, we are of considered view that this comparable has been rightly deleted since it is no longer uncontrolled transaction and cannot serve as comparable in benchmarking mechanism for present assessee, since RPT filter of this company failed to meet filter criteria of 25% of RPT, as applied by TPO. Tribunal in similarly situated case, deleted Wipro Technology Services Ltd, since it had ceased to be uncontrolled transaction under Section 92B (2) of Act. same order of deletion has been upheld by this Court in PCIT vs. Saxo India Pvt. Ltd., ITA 682/16vide order dated 28.09.2016.Theassessee therein was engaged in business of design and ITA 201/2018 Page 27 of 32 development of customized software applications. relevant paragraphs of Tribunal s order reads as under: 16.5. Adverting to facts of instant case, we find that Wipro Technology Services Ltd. earned revenue from Master services agreement with Citigroup Inc. for delivery of technology infrastructure services. This agreement was, in fact, executed between assessee s AE, Wipro Ltd., and Citigroup Inc., third person. This unfolds that transaction of earning revenue from software development support and maintenance services by Wipro Technology Services Ltd., is international transaction because of application of section 92B(2) i.e., there exists prior agreement in relation to such transaction between Citigroup Inc. (third person) and Wipro Ltd. (associated enterprise). In light of this structure of transaction, it ceases to be uncontrolled transaction and, hence, Wipro Technology Services Ltd., disqualifies to become comparable uncontrolled transaction for purposes of inclusion in final list of comparables under Rule 10B(1)(e)(ii). We, therefore, direct removal of this company from list of comparables. [Emphasis Supplied] 31. We also note that aforesaid comparable has been deleted in case of sister company of assessee herein. sister company of assessee also operates in same business segment as assessee. order of deletion has been upheld by this Court in CashEdge India (supra) for same AY 2010-11. Since, Courts have consistently upheld deletion of said comparable on account of failing Related Party Filter, we do not see any reason to interfere with Tribunal s order of deletion of Wipro Technology Services Ltd. ITA 201/2018 Page 28 of 32 32. This brings us to third and fourth comparable, Persistent Systems Ltd. and Thirdware Solutions Ltd., which were deleted on ground of being functionally dissimilar to assessee and on account of absence of segmental information with regard to their earnings and sales in field of software development. reasoning given by Tribunal for rejecting aforenoted two comparables is as follows: (iii) Persistent Systems Ltd.:- XXXX 9. We have heard rival submissions, perused relevant findings given in impugned order as well as material referred to before us. From perusal of annual report of PSL it is seen that this company deals with various products and it has been stated that it has realised more than 3000 products in last five years and it is leader in world of outsource software product development. break-up of income under head "software services and products" both exports and domestic, it is seen that there is no segmental information as to how much is revenue from software services and how much is from products. This is evident from detailed report given at page 46 of paper book. In absence of such segmental information it is very difficult to come to conclusion as to whether margin of this company also includes sale of products. Moreover, as pointed out by ld. Counsel, commission paid to agents on sales is also indicative of fact that there are sale of products. Thus, we find it very difficult to include such comparable into basket of comparables for bench marking assessee's margin and, accordingly, we direct TPO to exclude this comparable from list of comparable companies. (iv) Thirdware Solutions Ltd.:- XXXXX ITA 201/2018 Page 29 of 32 From above it is not clear as to what constitutes sale of exports, whether it is product or software development services. Revenue from subscription and sale of licence also indicate that there is income from products also which would indicate different business model and consequently profit margin. Without any proper segmental information regarding revenues from software development and software products, it would be very difficult to accept that proper comparability analysis can be carried out with assessee which is purely providing software development services. Apart from above it is noticed that in case of Fiserve, this comparable company has been excluded precisely on same ground and said order of Tribunal stands affirmed by Hon ble High Court also. Accordingly, we direct TPO to exclude said comparable from list of comparables. [Emphasis Supplied] 33. Both aforenoted comparables have been excluded on ground that apart from rendering software services, companies are engaged in sale of software products and segmental data of product and services is not available. Firstly, this is finding of fact and secondly, in grounds urged in present appeal, Revenue has not disputed this factual position. In note of arguments filed by appellant also, there is no challenge to this factual position. We would like to add that respondent had brought to our notice that this Court in CashEdge (supra)for very same AY 2010-11 and in identical business vertical i.e. captive software development services had upheld exclusion of Persistent Systems Ltd. With respect to Thirdware Solutions and Sales Limited, we find that ITAT has undertaken detailed factual analysis and has given cogent reasons for exclusion of comparables in question. ITAT has noted that there is ITA 201/2018 Page 30 of 32 no segmental data to work out separate margin from software services. Further, this comparable was also rejected in case of assessee's sister concern, Fiserv India Ltd on ground of non-availability of segmental data. said decision was affirmed by this court vide order dated 06.01.2016 in Pr. Commissioner of Income Tax-3 versus Fiserv India Pvt. Limited, ITA N0. 17/2016. absence segmental data is factual finding that is not in serious challenge before us. Thus, Court is not persuaded to find any infirmity in view taken by ITAT viz third and fourth comparables. 34. In view of above, it emerges that none of comparables have been excluded on ground of high turnover alone. test of functional similarity applied by Tribunal is in consonance with legal position discussed hereinabove. Therefore, we do not find merit in contentions urged by Revenue on this ground. Equally meritless is contention of Revenue regarding bar to challenge comparables after acceptance of filters. filters are applied to narrow down search to find comparables that are closest to assessee. use of filters has to be necessarily validated from annual reports. Since TPO would have to do this exercise on basis of actual data in report of comparables, he would surely have freedom to adopt or reject comparables. We cannot hold that merely because comparable clears filters, its inclusion in list of comparables is immune to challenge by assessee. ITA 201/2018 Page 31 of 32 35. In view of aforegoing discussion, question of law framed by us is answered against Revenue and in favour of assessee. appeal is dismissed with no order as to costs. SANJEEV NARULA, J VIPIN SANGHI, J MAY 18, 2020 v ITA 201/2018 Page 32 of 32 Principal Commissioner of Income-tax-7 v. Open Solutions Software Services Pvt. Ltd