A company involved in clinical research and manufacture of bio-products could not be accepted as valid comparable in case of software development services Provider
IN THE ITAT BANGALORE BENCH ‘A’
Mindteck (India) Ltd.
Income-tax Officer, Circle 12 (1), Bangalore
AND ABRAHAM P. GEORGE, ACCOUNTANT MEMBER
IT (TP) APPEAL NO. 1082 (BANG.) OF 2011
[ASSESSMENT YEAR 2007-08]
MAY 14, 2015
Sampath Raghunathan, Adv. for the Appellant. C.H. Sundar Rao, CIT-I (DR) for the Respondent.
N.V. Vasudevan, Judicial Member – This appeal by the assessee is against the order dated 19.09.2011 the ITO, Ward 12(1), Bangalore passed u/s. 143(3) r.w.s. 144C of the Act, in relation to A.Y.2007-08.
2. The Assessee has raised as much as 10 grounds of appeal in the grounds of appeal. Out of the 10 grounds raised in the grounds of appeal, Ground No. 1, Ground No. 2 & 3 are relating to Transfer Pricing adjustment on account of determination of ALP. Ground No. 2.5 to 7 and Ground No. 3 in so far as it relates to allowing working capital adjustment was alone pressed for adjudication. Ground No. 6 was not pressed for adjudication Ground No. 7 with regard to levy of interest u/s. 234A & B of the Act is purely consequential. Ground No. 8 with regard to initiation of penalty proceedings u/s. 271(1)(( c) of the Act cannot be subject matter of appeal. Ground No. 9 & 10 are general in nature and calls for no specific adjudication. Ground No. 4 is with regard to exclusion of foreign currency expenses and communication charges from the export turnover/total turnover. Ground No. 5 is with regard to the Revenue authorities in not allowing set-off of current year unabsorbed depreciation against the adjustment made to the business income.
3. Grounds 2.5 to 7 and ground No. 3 raised by the Assessee are with regard to the addition to the total income by way of adjustment to the Arms’ Length Price (“ALP”) to an international transaction carried out by the assessee u/s. 92CA of the Act. At the time of hearing of the appeal it was submitted that the comparable companies chosen by the TPO and the addition made by the AO in the draft assessment order which was confirmed by the DRP are identical to the case decided by the Tribunal in. July Sytstems & Technologies (P.) Ltd., v. ITO  48 taxmann.com 47 (Bang. – Trib.), 3DPLM Software Solutions Ltd. v. Dy. CIT  42 taxmann.com 333 (Bang. – Trib.), Element K. India (P.) Ltd. v. ITO,  54 taxmann.com 296 (Delhi – Trib.), CSR India (P.) Ltd. v. ITO  31 taxmann.com 265 (Bang. – Trib.), Toluna India (P.) Ltd. v. Asstt. CIT  151 ITD 177 (Delhi – Trib.), Trilogy E-Business Software India (P.) Ltd. v.Dy. CIT  140 ITD 540 (Bang. – Trib.), Yodlee Infotech v. ITO  57 SOT 457/31 taxmann.com 230 (Bang. – Trib.) as considered by this Tribunal in the case of Actiance India (P.) Ltd. v. ITO  52 taxmann.com 14 (Bang. – Trib.) It was also submitted that the business profile of the Assessee and that of the Assessee and the aforesaid cases are also identical. This submission was found to be correct at the time of hearing. With this background we will now consider the factual basis of the present case and the decision rendered in the case referred to above.
4. The assessee is a company. It is engaged in the business of rendering software development research and development services. The Assessee provides such services to its group companies apart from independent customers. The total operating revenue from rendering software development services was a sum of Rs. 23,57,26,348/-. Out of the above the revenue from rendering software development services to an Associated Enterprises (AE) was a sum of Rs. 18,58,84,791/-. It is not in dispute before us that the transaction of providing software research & development support services by the Assessee to its related party viz., group companies was an international transaction with the Associated Enterprise “(“AE”) and therefore the price at which the assessee renders services to its AE has to pass the Arm’s Length Price (ALP) test as laid down by section 92C of the Act.
5. In support of the assessee’s claim that the price charged by it for services rendered to its AE was at arms’ length, the assessee filed a report as required by the provisions of section 92E of the Act in Form 3EB together with detailed analysis. The assessee adopted Comparable Uncontrolled Price Method (CUP) as the most appropriate method for determining the ALP. The Assessee relied on the price charged by the AE to its customer was adopted. This was rejected by the TPO, who proceed to adopt Transaction Net Margin (TNMM) as the most appropriate method for determining ALP.
6. Operating profits to cost was adopted as the Profit Level Indicator (“PLI”). The PLI of the assessee was arrived at as follows:
|Operating Revenue||Rs. 18,58,84,791|
|Operating Cost||Rs. 17,68,70,698|
|Operating Profit||Rs. 90,14,093|
7. The TPO arrived at a final set of 26 comparables. The set of 20 comparables is as follows:
|Sl. No||Name of company||OP/TC||Turnover Rs. in Crores|
|1||Accel Transmatic Ltd (Seg.)||21.11%||9.68|
|2||Avani Cimcon Technologies Ltd||52.59%||3.55|
|3||Celestial Labs Ltd||58.35%||14.13|
|5||E-Zest Solutions Ltd||36.12%||6.26|
|6||Flextronics Software Systems Ltd (Seg.)||25.31%||848.66|
|7||Geometric Ltd (Seg.)||10.71%||158.38|
|8||Helios & Matheson Information Technology Ltd||36.63%||178.63|
|9||iGate Global Solutions Ltd||7.49%||747.27|
|10||Infosys Technologies Ltd||40.30%||131.49|
|11||Ishir Infotech Ltd||30.12%||7.42|
|12||KALS Information Systems Ltd (Seg.)||30.55%||2.00|
|13||LGS Global Ltd (Lanco Global Solutions Ltd)||15.75%||45.39|
|14||Lucid Software Ltd||19.37%||1.70|
|15||Mediasoft Solutions Ltd||3.66%||1.85|
|18||Persistent Systems Ltd||24.52%||293.75|
|19||Quintegra Solutions Ltd||12.56%||62.72|
|20||R S Software (India) Ltd||13.47%||101.04|
|21||R Systems International Ltd (Seg.)||15.07%||112.01|
|22||S I P Technologies & Exports Ltd||13.90%||3.80|
|23||Sasken Communication Technologies Ltd (Seg.)||22.16%||343.57|
|24||Tata Elxsi Ltd (Seg.)||26.51%||262.58|
|25||Thirdware Solutions Ltd||25.12%||36.08|
|26||Wipro Ltd (Seg.)||33.65%||961.09|
8. The assessee raised various objections to the methodology adopted and the reasons assigned by the TPO for rejecting the comparables chosen by the assessee in its TP study. The TPO finally passed an order u/s. 92CA of the Act and on the basis of the comparables set out above and arrived at arithmetic mean of 25.14%. The computation of the ALP by the TPO in this regard was as follows:—
“12.6 Computation of Arms Length Price:
The arithmetic mean of the Profit Level indicators is taken as the arms length margin. (Please see Annexure B For details of computation of PLI of the comparables). Based on this, the arms length price of the software development services rendered by the taxpayer to its AE(s) is computed below. It needs to be pointed out that allocation of cost in respect of AE transactions taken in this computation is the same as intimated to the taxpayer vide notice dated 11.6.2010. The taxpayer has not given any comments in this regard.
|Arms Length mean margin on cost
|Arms Length Margin||25.14% of the operating cost|
|Arms Length Price (ALP)
At 125.14% of operating cost Price received
Short fall being adjustment u/s. 92CA
12.7 Price received vis-à-vis the Arms Length Price:
The price charged by the tax payer to its Associated Enterprises is compared to the Arms Length Price as under:
|Arms Length Price (ALP)
At 125.14% of operating cost
|Price charged in the international transactions||Rs. 18,58,84,791|
|Shortfall being adjustment u/s. 92CA||Rs. 3,54,51,200|
The above shortfall of Rs. 3,54,51,200/- is treated as transfer pricing adjustment u/s 92CA.”
9. Against the said adjustment proposed by the TPO which was incorporated in the draft assessment order by the AO, the assessee filed objections before the DRP. The DRP rejected those objections and confirmed the transfer pricing adjustment suggested by the TPO. The adjustment confirmed by the DRP was added to the total income of the assessee by the AO in the fair order of assessment. Against the said order of the Assessing Officer, the assessee has preferred the present appeal before the Tribunal.
10. The ld. counsel for the assessee brought to our notice that out of the 26 comparable companies chosen by the TPO, the following companies will have to be excluded as the turnover of these companies are more than Rs. 200 crores and cannot be compared with the Assessee whose turnover is less than Rs. 200 crores:
|(1)||Flextronics Software Systems Ltd.|
|(2)||iGate Global Solutions Ltd.|
|(4)||Persistent Systems Ltd.|
|(5)||Sasken Communication Technologies Ltd.|
|(6)||Infosys Technologies Ltd.|
|(7)||Tata Elxsi Ltd.|
11. Our attention was drawn to the observations of the Tribunal in the case of Trilogy E-Business Software India (P.) Ltd.(supra) for assessment year (07-08) on the application of turnover filter and it was submitted that the aforesaid comparable companies have to be excluded from the final list of comparable selected by the TPO.
12. We have considered the submission of the learned counsel for the Assessee and the learned DR. In the case of Trilogy E-Business Software India (P) Ltd. (supra), this Tribunal on application of the turnover filter while selecting comparable companies for comparability analysis held as follows:
‘(1) Turnover Filter
11. The ld. counsel for the assessee submitted that the TPO has applied a lower turnover filter of RS. 1 crore, but has not chosen to apply any upper turnover limit. In this regard, it was submitted by him that under rule 10B(3) to the Income-tax Rules, it was necessary for comparing an uncontrolled transaction with an international transaction that there should not be any difference between the transactions compared or the enterprises entering into such transaction, which are likely to materially affect the price or cost charged or paid or profit arising from such transaction in the open market. Further it is also necessary to see that wherever there are some differences such differences should be capable of reasonable accurate adjustment in monetary terms to eliminate the effect of such differences. It was his submission that size was an important facet of the comparability exercise. It was submitted that significant differences in size of the companies would impact comparability. In this regard our attention was drawn to the decision of the Special Bench of the ITAT Chandigarh Bench in the case of Dy. CIT v. Quark Systems (P.) Ltd.  38 SOT 307, wherein the Special Bench had laid down that it is improper to proceed on the basis of lower limit of 1 crore turnover with no higher limit on turnover, as the same was not reasonable classification. Several other decisions were referred to in this regard laying down identical proposition. We are not referring to those decisions as the decision of the Special Bench on this aspect would hold the field. Reference was also made to the OECD TP Guidelines, 2010 wherein it has been observed as follows:—
“Size criteria in terms of Sales, Assets or Number of Employees: The size of the transaction in absolute value or in proportion to the activities of the parties might affect the relative competitive positions of the buyer and seller and therefore comparability.”
12. The ICAI TP Guidelines note on this aspect lay down in para 15.4 that a transaction entered into by a Rs. 1,000 crore company cannot be compared with the transaction entered into by a Rs. 10 crore company. The two most obvious reasons are the size of the two companies and the relative economies of scale under which they operate. The fact that they operate in the same market may not make them comparable enterprises. The relevant extract is as follows [on Rule 10B(3)]:
“Clause (i) lays down that if the differences are not material, the transactions would be comparable. These differences could either be with reference to the transaction or with reference to the enterprise. For instance, a transaction entered into by a Rs 1,000 crore company cannot be compared with the transaction entered into by a Rs 10 crore company. The two most obvious reasons are the size of the two companies and the relative economies of scale under which they operate.”
13. It was further submitted that the TPO’s range (Rs. 1 crore to infinity) has resulted in selection of companies like Infosys which is 277 times bigger than the Assessee (turnover of Rs. 13,149 crores as compared to Rs. 47.47 crores of Assessee). It was submitted that an appropriate turnover range should be applied in selecting comparable uncontrolled companies.
14. Reference was made to the decision of the ITAT Bangalore Bench in the case of Genesis Integrating Systems (India) (P.) Ltd. v. DCIT, ITA No. 1231/Bang/2010, wherein relying on Dun and Bradstreet’s analysis, the turnover of RS. 1 crore to Rs. 200 crores was held to be proper. The following relevant observations were brought to our notice:-
“9. Having heard both the parties and having considered the rival contentions and also the judicial precedents on the issue, we find that the TPO himself has rejected the companies which .ire (sic) making losses as comparables. This shows that there is a limit for the lower end for identifying the comparables. In such a situation, we are unable to understand as to why there should not be an upper limit also. What should be upper limit is another factor to be considered. We agree with the contention of the learned counsel for the assessee that the size matters in business. A big company would be in a position to bargain the price and also attract more customers. It would also have a broad base of skilled employees who are able to give better output. A small company may not have these benefits and therefore, the turnover also would come down reducing profit margin. Thus, as held by the various benches of the Tribunal, when companies which arc loss making are excluded from comparables, then the super profit making companies should also be excluded. For the purpose of classification of companies on the basis of net sales or turnover, we find that a reasonable classification has to be made. Dun & Bradstreet & Bradstreet and NASSCOM have given different ranges. Taking the Indian scenario into consideration, we feel that the classification made by Dun & Bradstreet is more suitable and reasonable. In view of the same, we hold that the turnover filter is very important and the companies having a turnover of Rs. 1.00 crore to 200 crores have to be taken as a particular range and the assessee being in that range having turnover of 8.15 crores, the companies which also have turnover of 1.00 to 200.00 crores only should be taken into consideration for the purpose of making TP study.”
15. It was brought to our notice that the above proposition has also been followed by the Honourable Bangalore ITAT in the following cases:
|1.||M/s Kodiak Networks (India) Private Limited v. ACIT (ITA No. 1413/Bang/2010)|
|2.||M/s Genesis Microchip (I) Private Limited v. DCIT (ITA No. 1254/Bang/20l0).|
|3.||Electronic for Imaging India Private Limited (ITA No. 1171/Bang/2010).|
It was finally submitted that companies having turnover more than Rs. 200 crores ought to be rejected as not comparable with the Assessee.
16. The ld. DR, on the other hand pointed out that even the assessee in its own TP study has taken companies having turnover of more than Rs. 200 crores as comparables. In these circumstances, it was submitted by him that the assessee cannot have any grievance in this regard.
17. We have considered the rival submissions. The provisions of the Act and the Rules that are relevant for deciding the issue have to be first seen. Sec. 92. of the Act provides that any income arising from an international transaction shall be computed having regard to the arm’s length price. Sec. 92-B provides that “international transaction” means a transaction between two or more associated enterprises, either or both of whom are non- residents, in the nature of purchase, sale or lease of tangible or intangible property, or provision of services, or lending or borrowing money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises, and shall include a mutual agreement or arrangement between two or more associated enterprises for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any one or more of such enterprises. Sec. 92- A defines what is an Associated Enterprise. In the present case there is no dispute that the transaction between the Assessee and its AE was an international transaction attracting the provisions of Sec. 92 of the Act. Sec. 92C provides the manner of computation of Arm’s length price in an international transaction and it provides:—
(1) that the arm’s length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method, having regard to the nature of transaction or class of transaction or class of associated persons or functions performed by such persons or such other relevant factors as the Board may prescribe, namely :-
|(a)||comparable uncontrolled price method;|
|(b)||resale price method;|
|(c)||cost plus method;|
|(d)||profit split method;|
|(e)||transactional net margin method;|
|(f)||such other method as may be prescribed by the Board.|
(2) The most appropriate method referred to in sub- section (1) shall be applied, for determination of arm’s length price, in the manner as may be prescribed:
Provided that where more than one price is determined by the most appropriate method, the arm’s length price shall be taken to be the arithmetical mean of such prices:
Provided further that if the variation between the arm’s length price so determined and price at which the international transaction has actually been undertaken does not exceed five per cent of the latter, the price at which the international transaction has actually been undertaken shall be deemed to be the arm’s length price.
(3) Where during the course of any proceeding for the assessment of income, the Assessing Officer is, on the basis of material or information or document in his possession, of the opinion that—
(a) the price charged or paid in an international transaction has not been determined in accordance with sub-sections (1) and (2); or
(b) any information and document relating to an international transaction have not been kept and maintained by the assessee in accordance with the provisions contained in sub-section (1) of section 92D and the rules made in this behalf; or
(c) the information or data used in computation of the arm’s length price is not reliable or correct; or
(d) the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by a notice issued under sub-section (3) of section 92D,
the Assessing Officer may proceed to determine the arm’s length price in relation to the said international transaction in accordance with sub-sections (1) and (2), on the basis of such material or information or document available with him:”
18. Rule 10B of the IT Rules, 1962 prescribes rules for Determination of arm’s length price under section 92C:—
“10B. (1) For the purposes of sub-section (2) of section 92C, the arm’s length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method, in the following manner, namely :—
(a) to (d)
(e) transactional net margin method, by which,—
(i) the net profit margin realised by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base;
(ii) the net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base;
(iii) the net profit margin referred to in sub- clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market;
(iv) the net profit margin realised by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii);
(v) the net profit margin thus established is then taken into account to arrive at an arm’s length price in relation to the international transaction.
(2) For the purposes of sub-rule (1), the comparability of an international transaction with an uncontrolled transaction shall be judged with reference to the following, namely:—
(a) the specific characteristics of the property transferred or services provided in either transaction;
(b) the functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to the transactions;
(c) the contractual terms (whether or not such terms are formal or in writing) of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions;
(d) conditions prevailing in the markets in which the respective parties to the transactions operate, including the geographical location and size of the markets, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition and whether the markets are wholesale or retail.
(3) An uncontrolled transaction shall be comparable to an international transaction if-
(i) none of the differences, if any, between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from, such transactions in the open market; or
(ii) reasonably accurate adjustments can be made to eliminate the material effects of such differences.
(4) The data to be used in analysing the comparability of an uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered into :
Provided that data relating to a period not being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared.”
19. A reading of the provisions of Rule 10B(2) of the Rules shows that uncontrolled transaction has to be compared with international transaction having regard to the factors set out therein. Before us there is no dispute that the TNMM is the most appropriate method for determining the ALP of the international transaction. The disputes are with regard to the comparability of the comparable relied upon by the TPO.
20. In this regard we find that the provisions of law pointed out by the ld. counsel for the assessee as well as the decisions referred to by the ld. counsel for the assessee clearly lay down the principle that the turnover filter is an important criteria in choosing the comparables. The assessee’s turnover is Rs. 47,46,66,638. It would therefore fall within the category of companies in the range of turnover between 1 crore and 200 crores (as laid down in the case ofGenesis Integrating Systems (India) Pvt. Ltd. v. DCIT, ITA No. 1231/Bang/2010). Thus, companies having turnover of more than 200 crores have to be eliminated from the list of comparables as laid down in several decisions referred to by the ld. counsel for the assessee. Applying those tests, the following companies will have to be excluded from the list of 26 comparables drawn by the TPO viz.,
|(1) Flextronics Software Systems Ltd.||848.66 crores|
|(2) iGate Global Solutions Ltd.||747.27 crores|
|(3) Mindtree Ltd.||590.39 crores|
|(4) Persistent Systems Ltd.||293.74 crores|
|(5) Sasken Communication Technologies Ltd.||343.57 crores|
|(6) Tata Elxsi Ltd.||262.58 crores|
|(7) Wipro Ltd.||961.09 crores.|
|(8) Infosys Technologies Ltd.||131.49 crores.’|
13. Respectfully following the aforesaid decision of the Tribunal in the case of Trilogy E-Business Software India (P.) Ltd.(supra) and Assessee’s case for AY 06-07, we hold that the aforesaid companies (listed at S. No. 6, 9, 10, 17, 18, 23, 24 and 26 of the final list of comparable companies set out in the chart given para-4 of this order) should be excluded from the list of comparable companies. The AO is directed to compute the Arithmetic mean by excluding the aforesaid companies from the list of comparable.
14. Improper selection of comparables: It was submitted by the learned counsel for the Assessee that the following two companies are not functionally comparable with that of the Assessee:—
|(a)||KALS Information Systems Limited|
|(b)||Accel Transmission Limited.|
In this regard our attention was drawn to the decision of the Hon’ble ITAT Bangalore Bench in the case of Trilogy E-Business Software India (P.) Ltd. (supra) wherein these companies were held to be not functionally comparable with that of a pure software developer like the Assessee.
15. The following were the relevant observations of the Tribunal on the aforesaid comparable companies in the case ofTrilogy E-Business Software India (P.) Ltd. (supra):
‘”(d) KALS Information Systems Ltd.
3. As far as this company is concerned, the contention of the assessee is that the aforesaid company has revenues from both software development and software products. Besides the above, it was also pointed out that this company is engaged in providing training. It was also submitted that as per the annual repot, the salary cost debited under the software development expenditure was Q 45,93,351. The same was less than 25% of the software services revenue and therefore the salary cost filter test fails in this case. Reference was made to the Pune Bench Tribunal’s decision of the ITAT in the case of Bindview India Private Limited v. DCI, ITA No. ITA No 1386/PN/1O wherein KALS as comparable was rejected for AY 2006-07 on account of it being functionally different from software companies. The relevant extract are as follows:
“16. Another issue relating to selection of comparables by the TPO is regarding inclusion of Kals Information System Ltd. The assessee has objected to its inclusion on the basis that functionally the company is not comparable. With reference to pages 185-186 of the Paper Book, it is explained that the said company is engaged in development of software products and services and is not comparable to software development services provided by the assessee. The appellant has submitted an extract on pages 185-186 of the Paper Book from the website of the company to establish that it is engaged in providing of I T enabled services and that the said company is into development of software products, etc. All these aspects have not been factually rebutted and, in our view, the said concern is liable to be excluded from the final set of comparables, and thus on this aspect, assessee succeeds.”
Based on all the above, it was submitted on behalf of the assessee that KALS Information Systems Limited should be rejected as a comparable.
4. We have given a careful consideration to the submission made on behalf of the Assessee. We find that the TPO has drawn conclusions on the basis of information obtained by issue of notice u/s. 133(6) of the Act. This information which was not available in public domain could not have been used by the TPO, when the same is contrary to the annual report of this company as highlighted by the Assessee in its letter dated 21.6.2010 to the TPO. We also find that in the decision referred to by the learned counsel for the Assessee, the Mumbai Bench of ITAT has held that this company was developing software products and not purely or mainly software development service provider. We therefore accept the plea of the Assessee that this company is not comparable.”
“(e) Accel Transmatic Ltd.
48. With regard to this company, the complaint of the assessee is that this company is not a pure software development service company. It is further submitted that in a Mumbai Tribunal Decision of Capgemini India (F) Ltd. v Ad. CIT 12 Taxman.com 51, the DRP accepted the contention of the assessee that Accel Transmatic should be rejected as comparable. The relevant observations of DRP as extracted by the ITAT in its order are as follows:
“In regard to Accel Transmatics Ltd. the assessee submitted the company profile and its annual report for financial year 2005-06 from which the DRP noted that the business activities of the company were as under.
(i) Transmatic system – design, development and manufacture of multi function kiosks Queue management system, ticket vending system
(ii) Ushus Technologies – offshore development centre for embedded software, net work system, imaging technologies, outsourced product development
(iii) Accel IT Academy (the net stop for engineers) – training services in hardware and networking, enterprise system management, embedded system, VLSI designs, CAD/CAM/BPO
(iv) Accel Animation Studies software services for 2D/3D animation, special effect, erection, game asset development.
4.3 On careful perusal of the business activities of Accel Transmatic Ltd. DRP agreed with the assessee that the company was functionally different from the assessee company as it was engaged in the services in the form of ACCEL IT and ACCEL animation services for 2D and 3D animation and therefore assessee’s claim that this company was functionally different was accepted. DRP therefore directed the Assessing Officer to exclude ACCEL Transmatic Ltd. from the final list of comparables for the purpose of determining TNMM margin.”
49. Besides the above, it was pointed out that this company has related party transactions which is more than the permitted level and therefore should not be taken for comparability purposes. The submission of the ld. counsel for the assessee was that if the above company should not be considered as comparable. The ld. DR, on the other hand, relied on the order of the TPO.
50. We have considered the submissions and are of the view that the plea of the assessee that the aforesaid company should not be treated as comparables was considered by the Tribunal in Capgemini India Ltd (supra) where the assessee was software developer. The Tribunal, in the said decision referred to by the ld. counsel for the assessee, has accepted that this company was not comparable in the case of the assessees engaged in software development services business. Accepting the argument of the ld. counsel for the assessee, we hold that the aforesaid company should be excluded as comparables.”
16. The facts and circumstances under which the aforesaid companies were considered as comparable is identical in the case of the Assessee as well as in the case of Trilogy E-Business Software India (P.) Ltd. (supra). Respectfully following the decision of the Tribunal referred to above in the case of Trilogy E-Business Software India (P.) Ltd. (supra), we direct that the following companies be excluded from the list of 26 comparable arrived at by the TPO.
|(a)||KALS information Systems Limited.|
|(b)||Accel Transmission Limited.|
17. As far as the comparable chosen by the TPO viz., Megasoft Ltd. in the list of final comparables chosen by the TPO is concerned, this Tribunal in the case of Trilogy E-Business Software India (P.) Ltd. (supra) had held that only segmental data of the said company should be taken for the purpose of comparison. Following are the relevant observations of the Tribunal:—
“37. The next plea of the Assessee is that if at all this company is considered as a comparable then the segmental margin of 23.11% (which is the margin for software service segment) alone should be considered for comparability. On the above submission, we find that the TPO considered the segmental margin (Software service segment) in the case of Geometric, Kals Info systems, R Systems, Sasken Communication and Tata Elxsi. Before DRP the Assessee pointed out that the segmental margin of 23.11% alone should be taken for comparability. The DRP has not given any specific finding on the above plea of the Assessee. Perusal of the order of the TPO shows that the TPO relied on information which was given by this company in which this company had explained that it has two divisions viz., BLUEALLY DIVISION and XIUS-BCGI DIVISION. Xius- BCGI Division does the business of product software (developing software). This company develops packaged products for the wireless and convergent telecom industry. These products are sold as packaged products to customers. While implementing these standardized products, customers may request the company to customize products or reconfigure products to fit into their business environment. Thereupon the company takes up the job of customizing the packaged software. The company also explained that 30 to 40% of the product software (software developed) would constitute packaged product and around 50% to 60% would constitute customized capabilities and expenses related to travelling, boarding and lodging expense. Based on the above reply, the TPO proceeded to hold that the comparable company was mainly into customization of software products developed (which was akin to software development) internally and that the portion of the revenue from development of software sold and used for customization was less than 25% of the overall revenues. The TPO therefore held that less than 25% of the revenues of the comparable are from software products and therefore the comparable satisfied TPO’s filter of more than 75% of revenues from software development services. Having drawn the above conclusion, the TPO did not bother to quantify the revenues which can be attributed to software product development and software development service but adopted the margin of this company at the entity level. In terms of Rule 10B(3)(b) of the Rules, an uncontrolled transaction shall be comparable to an international transaction if-
(i) none of the differences, if any, between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from, such transactions in the open market; or
(ii) reasonably accurate adjustments can be made to eliminate the material effects of such differences.
38. Neither the TPO nor the DRP have noticed that there is bound to be a difference between the Assessee and Megasoft and the profit arising to the Megasoft as a result of the existence of the software product segment and no finding has been given that reasonably accurate adjustments can be made to eliminate the material effects of such differences. For this reason, we are inclined to hold that the profit margin of 23.11% which is the margin of the software service segment be taken for comparability. In view of the above conclusion, we do not wish to go into the question as to whether less than 25% of the revenues of the comparable are from software products and therefore the comparable satisfied TPO’s filter of more than 75% of revenues from software development services.”
18. In view of the aforesaid decision of the Tribunal, segmental margins in so far as it relates to providing software services by Megasoft alone should be taken for the purpose of comparison.
19. The learned counsel for the Assessee brought to our notice that the comparable company chosen by the TPO at sl. No. 14 of the chart given in para-4 of this order viz., Lucid Software Limited, has to be excluded as functionally not comparable with that of the assessee in view of the decision of the Mumbai Bench of the Tribunal in the case of Telcordia Technologies India (P.) Ltd. v. Asstt. CIT  137 ITD 1 which was followed by the ITAT Bangalore Bench in the case of Logica (P.) Ltd. v. Asstt. CIT  36 taxmann.com 374, wherein it was held as under:—
“7.2 Lucid Software Limited
It has been submitted before us that this company, besides doing software development services, is also involved in development of software product. The learned AR has tried to distinguish by pointing out that product development expenditure in this case is around 39% of the capital employed by the said company, and, therefore, such a company cannot be considered as tested party. Even as per the information received in response to notice under Section 133(6), the company has described its business as software development company or pure software development service provider. This information itself is very vague as the segmental details of operating revenue has not been made available to examine how much is the ratio of sale from software product and sale of software service and development. Looking to the fact that it has developed a software product named as ‘Muulam’ which is used for civil engineering structures and the product development expenditure itself is substantial vis-a-vis the capital employed by the said company, this criteria for being taken as comparable party, gets vitiated. For the purpose of comparability analysis, it is essential that the characteristics and the functions are by and large similar as that of the assessee company and T.P. analysis/study can be made with fewest and most reliable adjustment. If a company has employed heavy capital in development of a product then profitability in the sale of product would be entirely different from the company, who is involved in service sector. Therefore, this company cannot be treated as having same function and profitability ratio.
In our view, due to non-availability of full information about the segmental details as to how much is the sale of product and how much is from the services, therefore, this entity cannot be taken into account for comparability analysis for determining arms length price in the case of the assessee.”
20. The facts and circumstances under which the aforesaid company were considered as comparable is identical in the case of the Assessee as well as in the case of Logica (P.) Ltd. (supra). Respectfully following the decision of the Tribunal referred to above in the case of Logica (P.) Ltd. (supra), we direct that the company listed as Sl. No. 14 of the list of comparable companies chosen by the TPO and listed in para-4 of this order to be excluded from the list of 20 comparable arrived at by the TPO.
21. As far as comparable company at Sl. No. 7 &11 of the chart of comparable companies chosen by the TPO at page-4 of this order viz., Geometric Software Ltd. (Seg.) & Ishir Infotech Ltd. are concerned, it is not in dispute before us that the related party transaction in the case of companies exceeds 15% (19.98 % in the case of Geometric Software Ltd. and 21.97% in the case of Ishir Infotech Ltd.) and in view of the decision of the Tribunal in the case of 24/7 Customer Com (P.) Ltd. v. Dy. CIT  140 ITD 344 (Bang.), followed by this Tribunal in the case of Logica (P.) Ltd. (supra) wherein it was held that where the RPT exceeds 15%, such companies should not be taken as comparable companies. Following the said decision, we hold that companies at Sl. Nos. 7 & 11 referred to above of the list of the comparable companies chosen by the TPO be excluded from the list of comparable companies while working out the ALP.
22. As far as comparables at Sl. Nos. 2 &, 3 of the list of comparables chosen by the TPO are concerned, this Tribunal in the case of Trilogy E- Business Software India (P.) Ltd. (supra) has taken a view that these companies are not comparable to the software service provider companies. The following are the relevant observations of the Tribunal in this regard:—
‘(b) Avani Cimcon Technologies Ltd.
39. As far as this company is concerned, the plea of the Assessee has been that this company is functionally different from the assessee. Based on the information available in the company’s website, which reveals that this company has developed a software product by name “DXchange”, it was submitted that this company would have revenue from software product sales apart from rendering of software services and therefore is functionally different from the assessee. It was further submitted that the Mumbai Bench of the Tribunal to the decision in the case of Telcordia Technologies Pvt. Ltd. v. ACIT – ITA No. 7821/Mum/2011 wherein the Tribunal accepted the assessee’s contention that this company has revenue from software product and observed that in the absence of segmental details, Avani Cincom cannot be considered as comparable to the assessee who was rendering software development services only and it was held as follows:—
“7.8 Avani Cincom Technologies Ltd. (‘Avani Cincom’):
Here in this case also the segmental details of operating income of IT services and sale of software products have not been provided so as to see whether the profit ratio of this company can be taken into consideration for comparing the case that of assessee. In absence of any kind of details provided by the TPO, we are unable to persuade ourselves to include it as comparable party. Learned CIT DR has provided a copy of profit loss account which shows that mainly its earning is from software exports, however, the details of percentage of export of products or services have not been given. We, therefore, reject this company also from taking into consideration for comparability analysis.”
It was also highlighted that the margin of this company at 52.59% which represents abnormal circumstances and profits. The following figures were placed before us:—
|Operating Margin||32.55%||52.59%||25.62%||– 9.87%|
40. It was submitted that this company has made unusually high profit during the financial year 06-07. The operating revenues increased 63.03% which indicates that it was an extraordinary year for this company. Even the growth of software industry for the previous year as per NASSCOM was 32%. The growth rate of this company was double the industry average. In view of the above, it was argued that this company ought to have been rejected as a comparable.
41. We have given a careful consideration to the submissions made on behalf of the Assessee and are of the view that the same deserves to be accepted. The reasons given by the Assessee for excluding this company as comparable are found to be acceptable. The decision of ITAT (Mumbai) in the case of Telcordia Technologies Pvt. Ltd. v. ACIT(supra) also supports the plea of the assessee. We therefore accept the plea of the Assessee to reject this company as a comparable.
(c) Celestial Labs Ltd.
42. As far as this company is concerned, the stand of the assessee is that it is absolutely a research & development company. In this regard, the following submissions were made:-
i. In the Director’s Report (page 20 of PB-Il), it is stated that “the company has applied for Income Tax concession for in-house R&D centre expenditure at Hyderabad under section 35(2AB) of the Income Tax Act.”
ii. As per the Notes to Accounts – Schedule 15, under “Deferred Revenue Expenditure” (page 31 of PB-II), it is mentioned that, “Expenditure incurred on research and development of new products has been treated as deferred revenue expenditure and the same has been written off in 10 years equally yearly installments from the year in which it is incurred.”
iii. An amount of Rs. 11,692,020/- has been debited to the Profit and Loss Account as “Deferred Revenue Expenditure” (page 30 of PB-II). This amounts to nearly 8.28 percent of the sales of this company.
It was therefore submitted that the acceptance of this company as a comparable for the reason that it is into pure software development activities and is not engaged in R&D activities is bad in law.
43. Further reference was also made to the decision of the Mumbai Bench of the Tribunal in the case of Teva Pharma Private Ltd. v. Addl. CIT – ITA No. 6623/Mum/2011 (for AY 2007-08) in which the comparability of this company for clinical trial research segment. The relevant extract of discussion regarding this company is as follows:
“The learned D.R. however drew our attention to page- 389 of the paper book which is an extract from the Directors report which reads as follows:
‘The Company has developed a de novo drug design tool “CELSUITE” to drug discovery in, finding the lead molecules for drug discovery and protected the IPR by filing under the copy if sic (of) right/patent act. (Apprised and funded by Department of Science and Technology New Delhi) based on our insilico expertise (applying bio-informatics tools). The Company has developed a molecule to treat Leucoderma and multiple cancer and protected the IPR by filing the patent. The patent details have been discussed with Patent officials and the response is very favorable. The cloning and purification under wet lab procedures are under progress with our collaborative Institute, Department of Microbiology, Osmania University, Hyderabad. In the industrial biotechnology area, the company has signed the Technology transfer agreement with IMTECH CHANDIGARH (a very reputed CSIR organization) to manufacture and market initially two Enzymes, Alpha Amylase and Alkaline Protease in India and overseas. The company is planning to set up a biotechnology facility to manufacture industrial enzymes. This facility would also include the research laboratories for carrying out further R & D activities to develop new candidates’ drug molecules and license them to Interested Pharma and Bio Companies across the GLOBE. The proposed Facility will be set up in Genome Valley at Hyderabad in Andhra Pradesh.’
According to the learned D.R. celestial labs is also in the field of research in pharmaceutical products and should be considered as comparable. As rightly submitted by the learned counsel for the Assessee, the discovery is in relation to a software discovery of new drugs. Moreover the company also is owner of the IPR. There is however a reference to development of a molecule to treat cancer using bio-informatics tools for which patenting process was also being pursued. As explained earlier it is a diversified company and therefore cannot be considered as comparable functionally with that of the Assessee. There has been no attempt made to identify and eliminate and make adjustment of the profit margins so that the difference in functional comparability can be eliminated. By not resorting to such a process of making adjustment, the TPO has rendered this company as not qualifying for comparability. We therefore accept the plea of the Assessee in this regard.’ ”
44. It was submitted that the learned DR in the above case vehemently argued that this company is into research in pharmaceutical products. The ITAT concluded that this company is owner of IPR, it has software for discovery of new drugs and has developed molecule to treat cancer. In the ultimate analysis, the ITAT did not consider this company as a comparable in clinical trial segment, for the reason that this company has diverse business. It was submitted that, however, from the above extracts it is clear that this company is not into software development activities, accordingly, this company should be rejected as a comparable being functionally different.
45. From the material available on record, it transpires that the TPO has accepted that up to AY 06-07 this company was classified as a Research and Development company. According to the TPO in AY 07-08 this company has been classified as software development service provider in the Capitaline/Prowess database as well as in the annual report of this company. The TPO has relied on the response from this company to a notice u/s. 133(6) of the Act in which it has said that it is in the business of providing software development services. The Assessee in reply to the proposal of the AO to treat this as a comparable has pointed out that this company provides software products/services as well as bioinformatics services and that the segmental data for each activity is not available and therefore this company should not be treated as comparable. Besides the above, the Assessee has point out to several references in the annual report for 31.3.2007 highlighting the fact that this company was develops biotechnology products and provides related software development services. The TPO called for segmental data at the entity level from this company. The TPO also called for description of software development process. In response to the request of the TPO this company in its reply dated 29.3.2010 has given details of employees working in software development but it is not clear as to whether any segmental data was given or not. Besides the above there is no other detail in the TPO’s order as to the nature of software development services performed by the Assessee. Celestial labs had come out with a public issue of shares and in that connection issued Draft Red Herring Prospectus (DRHP) in which the business of this company was explained as to clinical research. The TPO wanted to know as to whether the primary business of this company is software development services as indicated in the annual report for FY 06-07 or clinical research and manufacture of bio products and other products as stated in the DRHP. There is no reference to any reply by Celestial labs to the above clarification of the TPO. The TPO without any basis has however concluded that the business mentioned in the DRHP are the services or businesses that would be started by utilizing the funds garnered though the Initial Public Offer (IPO) and thus in no way connected with business operations of the company during FY 06-07. We are of the view that in the light of the submissions made by the Assessee and the fact that this company was basically/admittedly in clinical research and manufacture of bio products and other products, there is no clear basis on which the TPO concluded that this company was mainly in the business of providing software development services. We therefore accept the plea of the Assessee that this company ought not to have been considered as comparable.’
23. Respectfully following the decision referred to above, we hold that the aforesaid companies list at Sl. No. 2 & 3 of the list of comparables chosen by the TPO be excluded from the list of comparables.
24. As far as Helios & Matherson Information Technology Ltd., at Sl. No. 8 of the comparable companies chosen by the TPO is concerned, the ITAT Delhi in the case of Toluna India Pvt. Ltd., (supra) has held in para 23.1 & 23.2 of its order that this company cannot be regarded as a comparable company in the case of Software Development Service Provider such as the Assessee. In view of the above, the said company is directed to be excluded from the list of comparable companies.
25. As far as comparable at Sl. No. 5 of the list of comparable chosen by the TPO listed in the chart given at para-4 of this order viz., E-Zest Solutions Ltd., is concerned, the comparability of the aforesaid company with that of the software service provider was considered by the Bangalore Bench of ITAT in the case of 3DPLM Software Solutions Ltd. (supra) wherein on the comparability of the aforesaid company with a software development service provider, the Tribunal held as follows:—
“14. E-Zest Solutions Ltd.
14.1 This company was selected by the TPO as a comparable. Before the TPO, the assessee had objected to the inclusion of this company as a comparable on the ground that it was functionally different from the assessee. The TPO had rejected the objections raised by the assessee on the ground that as per the information received in response to notice under section 133(6) of the Act, this company is engaged in software development services and satisfies all the filters.
14.2 Before us, the learned Authorised Representative contended that this company ought to be excluded from the list of comparables on the ground that it is functionally different to the assessee. It is submitted by the learned Authorised Representative that this company is engaged in ‘e-Business Consulting Services’, consisting of Web Strategy Services, IT design services and in Technology Consulting Services including product development consulting services. These services, the learned Authorised Representative contends, are high end ITES normally categorised as knowledge process Outsourcing (‘KPO’) services. It is further submitted that this company has not provided segmental data in its Annual Report. The learned Authorised Representative submits that since the Annual Report of the company does not contain detailed descriptive information on the business of the company, the assessee places reliance on the details available on the company’s website which should be considered while evaluating the company’s functional profile. It is also submitted by the learned Authorised Representative that KPO services are not comparable to software development services and therefore companies rendering KPO services ought not to be considered as comparable to software development companies and relied on the decision of the co-ordinate bench in the case of Capital IQ Information Systems (India) (P) Ltd. in ITA No. 1961(Hyd)/2011 dt.23.11.2012 and prayed that in view of the above reasons, this company i.e. e-Zest Solutions Ltd., ought to be omitted from the list of comparables.
14.3 Per contra, the learned Departmental Representative supported the inclusion of this company in the list of comparables by the TPO.
14.4 We have heard the rival submissions and perused and carefully considered the material on record. It is seen from the record that the TPO has included this company in the list of comparables only on the basis of the statement made by the company in its reply to the notice under section 133(6) of the Act. It appears that the TPO has not examined the services rendered by the company to give a finding whether the services performed by this company are similar to the software development services performed by the assessee. From the details on record, we find that while the assessee is into software development services, this company i.e. e-Zest Solutions Ltd., is rendering product development services and high end technical services which come under the category of KPO services. It has been held by the co-ordinate bench of this Tribunal in the case of Capital I-Q Information Systems (India) (P) Ltd. (supra) that KPO services are not comparable to software development services and are therefore not comparable. Following the aforesaid decision of the co-ordinate bench of the Hyderabad Tribunal in the aforesaid case, we hold that this company, i.e. e-Zest Solutions Ltd. be omitted from the set of comparables for the period under consideration in the case on hand. The A.O./TPO is accordingly directed.”
26. The learned DR however submitted that the comparability of this company with a software development service provider was not objected to by Assessee’s who are in similar business in several cases like the case of Telcordia Technologies India (P.) Ltd. (supra) and Trilogy E- Business Software India (P.) Ltd. (supra). According to him the Assessee in the present appeal should not be permitted to take a plea that this company is not comparable. Besides the above, it was also his submission that the decision relied upon by the learned counsel for the Assessee relates to AY 07-08 whereas the case of the Assessee in this appeal relates to AY 08-09. According to him it needs to be verified as to whether the functional profile of this company chosen as comparable has changed in AY 08-09.
27. We have considered the submission of the learned DR and are of the view that the first objection raised by him is without any basis. The fact that one Assessee in the software development services sector accepts a company as a comparable does not bar any other Assessee in the same line of business to take a stand that such a company is not comparable. In this regard the important aspect to be noticed is that the Assessees in the cases cited by the learned DR have not raised a plea that the said company is not functionally comparable and the same has been rejected by the Tribunal. In other words the functional comparability of the said company has never been subject matter of investigation in any of the cases. In the present case the Assessee has chosen to object to this company being chosen as a comparable and the decision of the tribunal cited by the learned counsel for the Assessee supports his plea. There is no contrary decision brought to our notice to take a different view. We may also add that comparability and non-comparability of companies in the matter of determination of ALP is not dependent upon any concession either at the instance of the Assessee or the revenue. At any stage it can be demonstrated that a company chosen as a comparable is in fact not comparable and that which has been accepted as non-comparable is in fact comparable.
28. With regard to the objection of the leaned DR that the functional profile of the company E-Zest Solutions Ltd. in AY 07-08 has to be compared with that in AY 08-09 decided by the Tribunal, we accept the said prayer and for this limited purpose direct the TPO/AO to examine as to whether there is any change in the profile of the said company so that it can be regarded as comparable with an Assessee rendering software development service such as the Assessee.
29. The TPO is directed to compute ALP after excluding the comparable companies dealt with in this order. The TPO is also directed to take only the software development segment margin of the comparable company M/S.Megasoft Ltd., as was directed and held in the case of Trilogy E- Business Software India (P.) Ltd. (supra). The ground relating to Transfer pricing are decided accordingly.
30. Ground No. 4 raised by the Assessee project the grievance of the Assessee regarding the action of the learned Assessing Officer and Honorable Dispute Resolution Panel excluding expenses incurred on travel expenses in foreign currency and expenses incurred towards communication expenses from export turnover on the ground that these expenses are incurred in rendering technical services rendered to clients outside India, while computing deduction under section 10A. It is the plea of the Assessee that at all times during the relevant previous year, it was engaged in development of computer software and not in rendering any technical services. Without prejudice to its contention that the aforesaid sums should not be excluded from the export turnover while computing deduction u/s. 10A of the Act, the Assessee has also made an alternate prayer that expenses that are reduced from the export turnover should also be reduced from the total turnover and in this regard has placed reliance on the decision of the Hon’ble Karnataka High Court in the case of CIT v. Tata Elxsi Ltd.  349 ITR 98
31. We have heard the ld. counsel for the assessee and the ld. DR on the issues raised in ground No. 4. Taking into consideration the decision rendered by the Hon’ble High Court of Karnataka in the case of Tata Elxsi Ltd. (supra), we are of the view that it would be just and appropriate to direct the Assessing Officer to exclude expenses incurred in foreign currency towards travelling and expenses incurred towards communication both from export turnover and total turnover, as has been prayed for by the assessee in ground No. 9(d). In view of the acceptance of the alternative prayer in ground No. 4, we are of the view that no adjudication is required on the question whether the said expenses have to be excluded from Export Turnover or not.
32. Ground No. 5 raised by the Assessee reads as follows:
“The Assessing officer erred in not granting set-off of current year unabsorbed depreciation against the adjustments made to the business income.”
33. The Assessee filed return of income for AY 06-07 declaring loss of Rs. 10,53,268/-. The AO in page 5 of his order computed total income treating income declared in the return as “Nil”. Despite specific objection No. 7 by the Assessee in this regard before the DRP, the DRP did not consider the claim of the Assessee. We are of the view that it would just and appropriate to direct the AO to verify the claim of the Assessee for set off of current year unabsorbed depreciation against the adjustments made to the business income, if the claim of the Assessee is found to be correct, the AO shall give consequential relief to the Assessee.
34. In the result, appeal by the Assessee is partly allowe