Payment for purchase of software is not royalty/ fees for Technical Services, hence no TDS u/s 195

By | July 27, 2016

Held

AO/DRP have erred in treating the acquisition of software under the head ‘fee for technical services/royalty’ requiring the assessee to pay the tax on the same. [para 30]

IN THE ITAT DELHI BENCH ‘I-1’

SAIC India (P.) Ltd.

v.

Deputy Commissioner of Income-tax, Circle 7(1), New Delhi

KULDIP SINGH, JUDICIAL MEMBER
AND N. K. SAINI, ACCOUNTANT MEMBER

IT APPEAL NO. 6464 (DELHI) OF 2012
[ASSESSMENT YEAR 2008-09]

JUNE  27, 2016

S.D. Kapila, R.R. Maurya, Sanjay Kumar, Advs. and Pankaj, CA for the Appellant. Piyush Jain, CIT – DR for the Respondent.

ORDER

Kuldip Singh, Judicial Member – Appellant, M/s. SAIC India Private Limited (hereinafter referred to as ‘the assessee’), by filing the present appeal sought to set aside the impugned order passed by the AO/TPO/DRP qua the assessment year 2008-09 on the grounds inter alia that :-

I. Corporate Tax Grounds

1. That on the facts and in the circumstances of the case and in law, the Ld. AO erred in holding that the expenditure incurred in relation to Recruitment and Training of employees is enduring in nature and thereby allowing deduction of only 1/5th of the total expenditure of Rs.53,90,160 only.

2. That on the facts and circumstances of the case and in law, the Ld. AO erred in holding that the quality audit expense for certification is not in the nature of revenue expenditure and thereby disallowing sum of Rs.3,60,220.

3. That on the facts and circumstances of the case and in law, the Ld. AO erred in disallowing sum of Rs.1,80,120 for purchase of software under section 40 (a) of the Act holding such payment to be covered under the head fee for technical services / royalty and thereby holding that the assessee was required to withhold taxes on such payment.

4. That on the facts and circumstances of the case and in law, the Ld. AO erred in treating the payment of Rs.1,68,17,587 towards Retention Bonus as capital expenditure to be spread over five years and thereby allowing deduction of Rs.42,04,257, being only 1/5th of the expenditure.

II. Transfer Pricing Grounds

5. That on the facts and in the circumstances of the case and in law, the order passed by the Ld. AO is bad in law and void ab-initio.

6. The Ld. AO/Ld. TPO erred on facts and circumstances of the case in determining the arm’s length adjustment under section 92CA(3) of the act, to the Assessee’s international transactions and thereby making an addition of Rs.83,695,508.

7. That the reference made by the Ld. AO suffers from jurisdictional error as the Ld. AO has not recorded any reasons in the assessment order based on which he reached the conclusion that it was “expedient and necessary” to refer the matter to the Ld. TPO for computation of the arm’s length price, as is required under section 92CA(1).

8. The Ld. TPO erred in law in:-

8.1 Committing breach of principal of natural justice by changing the margins of certain comparable companies in his order and thus adopting profit margins different from those indicated in the show-cause notice issued to the Appellant.

8.2 That the Ld. DRP erred in not considering the Assessee’s explanation in respect of determination of ALP by the TPO.

9. The Ld. AO/Ld. TPO/Ld. DRP erred in-rejecting Appellant’s plea that keeping in view the peculiar facts of the case this year, the Proviso to Rule 10B(4) of the Income Tax Rules, 1962 .

10. The Ld. AO/Ld. TPO/Ld. DRP erred on facts and in law in determining the arm’s length price of the international transactions:-

10.1 In rejecting, arbitrarily the comparability analysis conducted by the Assessee for determining the arm’s length price on the basis of surmises and presumptions.

10.2 In not taking into consideration the fact that, during the year under consideration, the Assessee had undergone a change in its business structure and this extraordinary event was a material factor for the purpose of determining the arm’s length profit margin. It may be noted that the Assessee has maintained high profitability in all the prior and preceding years. Thus, the same should have been considered while evaluating the transfer pricing analysis for the Assessee.

10.3 In rejecting the comparable companies adopted by the Assessee on the basis of additional or modified filters applied by him, which lacked valid and sufficient reasoning.

10.4 In rejecting the companies which are functionally comparable to the Assessee. Similarly, the Ld. AO/TPO erred by retaining companies which were not comparable to the Assessee.

10.5 In not providing adjustment for the differences in the working capital profile of the Assessee vis a vis comparables.

10.6 In including retention bonus as a part of operating expenses.

11. The Ld. AO/TPO erred in facts and in law in not providing Assessee any opportunity of being heard on subjective grounds taken by him.

12. The Ld. AO/TPO erred in law in not giving the full effect to the directions of DRP.

13. The learned TPO and the learned AO erred in not allowing the benefit of range of +/- 5% as provided in proviso to Section 92C(2) of the Act to the Appellant, while determining the arm’ s length price.

14. The Ld. AO erred in determining interest U/S 234B and 234C of the Income Tax Act.”

2. Briefly stated the facts of this case are : a reference has been made by the AO under section 92CA (3) of the Income-tax Act, 1961 (for short ‘the Act’) to the Transfer Pricing Officer (TPO) to determine the Arm’s Length Price (ALP) in respect of the international transactions entertained into by the assessee during the financial year 2007-08. Assessee company is a provider of engineering and technology application solution and concentrates on using its domain knowledge to provide solution to wide range of industries viz. energy, environment, financial services, health care, life sciences, national security, space, telecommunications, transport, etc.

3. Assessee company engaged in the profession of software development services to its group company during the financial year 2007-08. The assessee company formerly known as SCICOM Technologies Private Limited which was acquired by SAIC USA in September 2007 and consequently, the branch office of SAIC based in Bangalore was merged with Scicom Technologies Pvt. Ltd. w.e.f. December 2007. Prior to the acquisition of SAIC, the company acted as an entrepreneur and the transfer pricing arrangement between the company and its marketing subsidiary was based on a revenue split. During the year under assessment, assessee company entered into international transaction as under:—

Nature of transaction Method Value
1 Provision of Software Development Services TNMM 404,411,559
2 Cost reimbursement paid TNMM 4,972,708
3 Reimbursement received Cup 10,349,580

4. Assessee company to benchmark its international transaction for provision of software development services adopted TNMM as the most appropriate method and computed the test party margin at 12.08%. Assessee selected 25 comparables, used three years data and computed their mean margin at 13.74% and claimed its international transaction at arm’s length.

5. TPO, when compared the tested party margin with profit & loss account of the assessee, noticed that a sum of Rs.1,70,00,000/- being the retention bonus paid to the employees has been treated as non-operating expenditure and consequently, reduced from total expenditure and similarly another sum of Rs.66,84,551/- being the foreign exchange fluctuation has been treated as non-operating whereas both these items are in the nature of operating expenses. Accordingly, assessee was called upon to treat retention bonus of Rs.1,70,00,000/- and foreign exchange fluctuation of Rs.66,84,551/- as operating expenses computed as under :—

Operating Revenue Rs.46,16,24,534/-
Operating Cost (Revised) Rs.43,55,59,139/-
Operating Profit Rs. 2,60,65,395/-
OP/OC 5.98%

6. Ld. TPO, after considering the contentions made by the assessee, came to the conclusion that retention bonus paid by the assessee company is to protect its revenue and is paid to earn operational income and thus to be treated as operating expenditure and recomputed the tested party margin of OP/OC at 5.98%.

7. Ld. TPO applied the filters viz. functional profile, companies having export sales of more than 25% of the total income, companies having employee cost to total cost of 25%; related party transaction is considered at 25% and used the data for financial year 2007-08 for benchmarking the international transaction.

8. By applying the aforesaid filters, the ld. TPO, out of 25 comparables chosen by the assessee for benchmarking its international transaction, accepted 5 comparables only and proposed to select 10 comparables having arithmetic mean at 27.02%. After considering the objections raised by the assessee, TPO has chosen 10 final comparable companies having mean margin of 26.79%. The ld. TPO also considered the segmental result of Kals Information System Ltd., R System International and Sasken Communication Technologies Ltd. and consequently made an adjustment of Rs.9,06,20,898/- between the difference in ALP and the price charged by the assessee from its Associated Enterprises (AEs) for export services.

9. Assessee carried the matter before the DRP by raising objection to certain comparables selected by ld. TPO viz. :

i. Aarman Software Private Limited
ii. Ace Software
iii. Bells Softech Limited
iv. CG-VAK Software & Exports Limited
v. Hypersoft Technologies Limited
vi. ICSA India Limited
vii. IKF Technologies
viii. Melstar Information Technologies Limited
ix. Prithvi Information Solutions Limited
x. Synetairos Technologies Limited
xi. Vishesh Infotecnics
xii. Maars Software International Limited

Agreeing with the contentions raised by the assessee company, all the aforesaid 12 comparables have been ordered to be rejected by the ld. DRP. However, DRP despite raising specific objection as to functional dis-similarity found FCC Software Solutions Limited as a correct comparable and also allowed the contention of the assessee company as to Kals Information System Limited.

10. Ld. DRP also directed the TPO to exclude foreign exchange fluctuation from operating income/loss of the assessee/comparables by accepting the contentions raised by the assessee. However, ld. DRP ratified the observation made by AO as to disallowing a sum of Rs.43,12,128/- out of staff recruitment expenses of Rs.53,90,160/- and training expenses of Rs.16,01,153/- after allowing 1/5th of these expenses and retention bonus expenses. Feeling aggrieved, the assessee company has come up before the Tribunal by way of filing the present appeal.

11. We have heard the ld. Authorized Representatives of the parties to the appeal, gone through the documents relied upon and orders passed by the revenue authorities below in the light of the facts and circumstances of the case.

12. At the very outset, ld. AR for the assessee by moving an application under Rule 11 of the Income Tax Appellate Tribunal Rules sought to raise the additional ground as under :—

“That on the facts and in circumstances of the case the authorities below should have excluded following comparables:-

1. Bodhtree Consulting Ltd.
2. Zylong Systems Ltd.
3. Lanco Global Systems Ltd.
4. Goldstone Technologies Ltd.
5. FCS Software Solutions Ltd.
6. Kals Information System Ltd.”

On the grounds inter alia that the assessee has sought to exclude FCC Software and Kals Information before the lower revenue authorities but rejected the plea raised by the assessee; that the plea raised by the assessee for exclusion of the companies referred in the additional ground is based upon the findings and rulings of the Tribunal which were not available in the public domain at that time; that the assessee cannot be estopped to seek exclusion of the comparables from the final list of comparables and relied upon the judgment cited as (i) Kedarnath Jute Mfg. Co. Ltd. v. CIT [1971] 82 ITR 363 (SC); (ii) CWT v. Meattles (P.) Ltd. [1985] 156 ITR 569 (Delhi); (iii) CIT v. Mrs. V. Chandra [2000] 245 ITR 610 (Delhi); (iv) Director of Inspection of Income-tax (Inv.) v. Pooran Mall & Sons [1974] 96 ITR 390 (SC); (v) PV Doshi v. CIT [1978] 113 ITR 22 (Guj.).

13. However, on the other hand, ld. DR opposed the application on the grounds inter alia that the assessee cannot be allowed to para-drop favourable comparables and exclude unfavourable ones at this stage as it has been granted full opportunity to choose the correct comparables before TPO; that except Bothtree Consulting Limited, none of the comparables now sought to be introduced by the assessee has been taken before the TPO; that taking new comparables at this stage would cause prejudice to the revenue as complete search of the new comparables is not possible at this stage.

14. Keeping in view the ratio of the judgments (supra) referred to in the preceding paras relied upon by the assessee that even if a particular plea factual or legal not taken by the assessee before the lower authorities out of ignorance or negligence, they cannot be estopped from taking a correct view later on before the appellate authority; that though admission is an admissible piece of evidence but it cannot be said to be conclusive as it is open to the person who made the admission to show that it is incorrect; that the assessee is entitled to argue before the appellate authorities that a wrong stand taken at the time of filing of return of income should be allowed to be modified; that in case, the assessee has not included correct comparable in its TP study nor sought to exclude the comparables chosen by the TPO, the assessee cannot be estopped from furnishing the correct position regarding comparables at any stage of the proceedings, we are of the considered view that to arrive at the logical conclusion as to benchmarking the international transaction undertaken by the assessee during the year under assessment, new set of comparables now sought to be excluded by way of additional evidence is necessary for complete adjudication of the controversy at hand. So far as question of causing prejudice to the revenue at this stage is concerned, it would amount to prejudging the issue sought to be raised by the assessee by way of additional ground, because question of comparability, if any, is ultimately to be determined by the TPO by providing an opportunity to be heard to the parties. So, we hereby allow the application under consideration without prejudice to the merits of the case.

15. Though corporate tax grounds as well as transfer pricing grounds are inter-linked but, for the sake of brevity, all the grounds under both the heads are being discussed separately.

Corporate Tax Grounds Ground No. 1

16. AO/DRP disallowed a sum of Rs.43,12,128/- out of recruitment expenses of Rs.37,89,007/- and training expenses of Rs.5,39,01,601/- by allowing 1/5th of these expenses by treating the same as enduring benefit to the assessee company as its benefit do not restrict one year only and remaining to be apportioned in the next five years. DRP also agreed with the AO and observed that recruitment and training expenses gave long term benefit to the company because the recruited and trained employees are generally working not for the year in which they are recruited but they contribute to the profit of the company for a long period.

17. Ld. AR for the assessee contended that recruitment and training expenses incurred by the assessee are revenue expenditure, hence allowable and relied upon judgment cited as Hindustan Aluminium Corpn. Ltd. v. CIT [1986] 159 ITR 673  (Cal.) and CIT v. Munjal Showa Ltd. [2010] 329 ITR 449 (Delhi).

18. Hon’ble Supreme Court in judgment cited as Hindustan Aluminium Corporation Ltd. (supra) while deciding the identical issued held as under :—

“Capital or Revenue Expenditure – Assessee establishing factory for manufacture of aluminium – expenditure incurred in sending some employees to U.S.A. For practical training and experience in running factory – Training given to achieve efficient running of factory for gaining optimum production – Directly linked to profit earning process – Is revenue expenditure – Expenditure incurred for prospective and searching bauxite mines – Bauxite raw material for production of aluminium – Expenditure was for earning profits – Is revenue expenditure and an allowable deduction – Income-tax Act, 1961, S. 37.”

19. Similarly, Hon’ble jurisdictional High Court in judgment cited as CIT v. Munjal Showa Ltd. (supra) while deciding the identical issue held as under :—

“Capital or revenue expenditure – Fees paid to foreign company for designs and drawings and expenses on foreign technicians for training assessee’s personnel – Expenditure for facilitating process of manufacture – Expenses incurred are revenue expenditure – Income-tax Act, 1961.”

20. Now, adverting to the case at hand, when the assessee has come up with specific pleas that he has made payment of Rs.37,89.007/- to the third party recruitment agency, access fee to various job sites like naukari.com etc. and Rs.16,01,153/- for imparting training to the new employees who have recently joined and on job training to existing employees, which have otherwise been not disputed by the AO/DRP, recruitment of employees for efficient profit earning through a recruitment agency is recurring process and such expenditure cannot be avoided / deferred. At the same time, in the globalised set up, sudden upgradation of knowledge and skill of the IT engineers / technicians for providing IT Software Development Services particularly to foreign AE is also necessary for earning profit by a company. Moreover, when undisputedly there is no memorandum of understanding between the assessee company and its employees that the employee will work for specific period, as the attrition rate in software industry is highest, recruitment of employees and imparting of training to them cannot be considered as of enduring benefit. So, by following the law laid down by the Hon’ble Calcutta High CourtHindustan Aluminium Corpn. Ltd. (supra) and Hon’ble jurisdictional High Court in Munjal Showa Ltd., (supra) we hereby decide ground no.1 in favour of the assessee.

Ground No. 2

21. AO, in compliance to the directions issued by the ld. DRP, made addition of Rs.3,60,220/- debited by the assessee to the profit and loss account during the year under assessment being expenditure on quality audit by treating the same as capital expenditure being in the nature of enduring benefit to the company. Ld. AR for the assessee contended that quality data expenses are in the nature of revenue expenditure necessary for smooth conduct of business and also is the requirement of many clients with such certificate be obtained before awarding the contract. The ld. AR for the assessee further contended that quality data is just to facilitate the assessee’s trading operations and conduct of business in a more profitable manner; that the expenditure would be of revenue nature even though the advantage may endure for an indefinite future and relied upon the judgment of the Hon’ble Supreme Court cited as Empire Jute Co. Ltd. v. CIT [1980] 124 ITR 1 . Hon’ble Apex Court while examining the nature of revenue expenditure held as under :—

“(ii) There may be cases where expenditure, even if incurred for obtaining an advantage of enduring benefit, may, none the less, be on revenue account and the test of enduring benefit may break down. It is not every advantage of enduring nature acquired by an assessee that brings the case within the principle laid down in this test. What is material to consider is the nature of the advantage in a commercial sense and it is only where the advantage is in the capital field that the expenditure would be disallowable on an application of this test. If the advantage consists merely in facilitating the assessee’s trading operations or enabling the management and conduct of the assessee’s business to be carried on more efficiently or more profitably while leaving the fixed capital untouched, the expenditure would be on revenue account, even though the advantage may endure for an indefinite future. The test of enduring benefit is, therefore, not a certain or conclusive test and it cannot be applied blindly and mechanically without regard to the particular facts and circumstances of a given case.

(iii) What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process. The question must be viewed in the larger context of business necessity or expediency.”

22. Keeping in view the fact that the expenditure on account of quality audit incurred by the assessee even if treated to be of enduring nature, it is to be treated as expenditure in the nature of revenue field as the test of benefit of enduring nature breaks down in this case. Because quality audit creates positive image of the product of the assessee; it fulfills the requirement of certain clients which contracts with the assessee company only with such certification; that by making such expenditure, assets of the assessee company has not been enhanced in any manner. So, we are of the opinion that DRP has erred in deciding this issue against assessee. Consequently, ground no.2 is determined in favour of the assessee.

Ground No. 3

23. Assessee claimed to have incurred expenses of Rs.3,00,200/- for purchase of PTC software. AO, in compliance to the directions passed by the ld. DRP, made addition of Rs.1,80,120/- on the ground that the assessee has failed to comply with the provisions of section 195 of the Act and disallowed the amount of depreciation amounting to Rs.1,80,120/-.

24. Ld. AR challenging the impugned order contended inter alia that provisions contained u/s 40(a)(i) are not applicable to depreciation; that depreciation is a statutory deduction and it is obligatory for the AO to allow the deduction of deprecation irrespective of the claim of the assessee.

25. Now the question arises for determination is “as to whether the AO/DRP have erred in treating the payment for acquisition of software as fee for technical services/royalty.”

26. Ld. DRP, while relying upon the decision rendered by ITAT, Delhi in the case of Grarcemac Corp. v. Asstt. DIT [2010] 42 SOT 550 held that the consideration for acquiring such software was royalty which was taxable in India u/s 9(1)(vi) and Article 12 of DTAA, amended by Finance Act, 2012 with retrospective effect and it is provided therein that royalty includes payment for transfer of any right to use computer software and tax was required to be deducted at source and ratified the order passed by the AO in disallowing the deduction for such payment u/s 40(1)(i) on ground of the non-deduction of tax at source.

27. However, Hon’ble jurisdictional High Court in judgment cited as DIT v. Infrasoft Ltd. [2014] 220 Taxman 273 (Delhi) made a distinction between royalty paid and consideration for transfer of copyrighted articles to decide the issue if royalty is to be paid in case of purchase of computer software by making following observations :—

“89. There is a clear distinction between royalty paid on transfer of copyright rights and consideration for transfer of copyrighted articles. Right to use a copyrighted article or product with the owner retaining his copyright, is not the same thing as transferring or assigning rights in relation to the copyright. The enjoyment of some or all the rights which the copyright owner has, is necessary to invoke the royalty definition. Viewed from this angle, a non-exclusive and non- transferable licence enabling the use of a copyrighted product cannot be construed as an authority to enjoy any or all of the enumerated rights ingrained in Article 12 of DTAA. Where the purpose of the licence or the transaction is only to restrict use of the copyrighted product for internal business purpose, it would not be legally correct to state that the copyright itself or right to use copyright has been transferred to any extent. The parting of intellectual property rights inherent in and attached to the software product in favour of the licensee/customer is what is contemplated by the Treaty. Merely authorizing or enabling a customer to have the benefit of data or instructions contained therein without any further right to deal with them independently does not, amount to transfer of rights in relation to copyright or conferment of the right of using copyright. The transfer of rights in or over copyright or the conferment of the right of use of copyright implies that the transferee/licensee should acquire rights either in entirety or partially co-extensive with the owner/ transferor who divests himself of the rights he possesses pro tanto.

90. The license granted to the licensee permitting him to download the computer programme and storing it in the computer for his own use is only incidental to the facility extended to the licensee to make use of the copyrighted product for his internal business purpose. The said process is necessary to make the programme functional and to have access to it and is qualitatively different from the right contemplated by the said paragraph because it is only integral to the use of copyrighted product. Apart from such incidental facility, the licensee has no right to deal with the product just as the owner would be in a position to do.

91. There is no transfer of any right in respect of copyright by the Assessee and it is a case of mere transfer of a copyrighted article. The payment is for a copyrighted article and represents the purchase price of an article and cannot be considered as royalty either under the Income Tax Act or under the DTAA.”

28. Judgment cited as Infrasoft Ltd. (supra) is applicable to the facts and circumstances of the case in which undisputedly no licence has been issued by the AEs in favour of the assessee for transfer of copyrights but assessee has merely paid the consideration for transfer of copyrighted article in the form of PTC software and as such, exclusive right has not been transferred in favour of the assessee qua the software purchased by it rather assessee’s right was restricted to use the copyrighted product for internal business purpose.

29. Identical issue has been dealt with by the Tribunal in case cited as SMS Demag (P.) Ltd. v. Dy. CIT [2010] 38 SOT 496 (Delhi), the operative part of the findings are as under:—

“Section 40(a)(i) of the Income-tax Act, 1961, read with article 24 of the DTAA between India and Germany – Business disallowance – Interest, etc., payable outside India – Assessment year 2000-01 – Assessee paid certain amount to ‘AG’, its parent company in Germany for purchase of software ‘SAP’ – It claimed deduction on said payment – Assessing Officer disallowed assessee’s claim on ground that said amount paid by assessee to its parent company was in nature of royalty/fees for technical services and was chargeable to tax in India – Whether payment made for purchase of software cannot be treated either as royalty or fees for technical services – Held, yes – Whether therefore, payment for SAP software could not be charged to tax in India as interest or royalty or fee for technical services – Held, yes – Whether even otherwise because of non-discriminatory clause 24(1) of DTAA with India and Germany, foreign national could not be subjected to provisions of section 40(a)(i) and, therefore, amount paid by assessee for acquisition of computers could not be taxed in India – Held, yes”

30. So, by following the judgments in case of Infrasoft Ltd. and SMS Demag (P.) Ltd. (supra), we are of the considered view that AO/DRP have erred in treating the acquisition of software under the head ‘fee for technical services/royalty’ requiring the assessee to pay the tax on the same.

Transfer Pricing Grounds

Grounds No. 4, 5, 6, 9 & 10.1 to 10.6

31. All these grounds are inter-linked and are taken up together to avoid repetition of discussion. First of all we would like to examine the issue of allowability and the retention of bonus claimed by the assessee company as it has direct impact on TP adjustment.

32. Assessee debited an amount of Rs.2,10,21,984/- on account of retention bonus paid to its employees, out of which AO/DRP disallowed an amount of Rs.1,68,17,587/- being 4/5th of the total liability of Rs.2,10,21,984/- by treating the same as capital expenditure on the grounds that the said expenditure was incurred due to amalgamation of Bangalore branch of US company by the assessee which is to be amortized over a period of five successive years in equal proportion by invoking the provisions of section 35DD of the Act and that the retention bonus paid to the employees are not in the nature of normal business expenditure but expenditure which would result into enduring benefit.

33. Undisputedly, an amount of Rs.2,10,21,984/- on account of retention bonus was paid by the assessee company prior to filing of the income-tax return.

34. Ld. AR for the assessee contended that AO/DRP have erred in treating the “retention bonus” as amalgamation expenses because it was not a case of amalgamation rather it was a case of sale of Bangalore branch of US company by the assessee company.

35. In the backdrop of the aforesaid facts and circumstances, the first question arises for determination in this case is “as to whether transfer of business of one of the branch of SAIC Group of USA to the assessee company on November 30, 2007 amounts to amalgamation or sale of the branch of US branch?”

36. Bare perusal of the assessment order as well as order passed by the DRP and material brought on record by the parties go to prove that the business of the SAIC Group, USA branch has been transferred to the assessee and in consideration thereof, the assessee issued shares to SAIC Group, USA. Assessee company stated to have paid the bonus to the erstwhile employees of transferring company to ensure the smooth functioning of the business. So, there is no material on file to arrive at the conclusion that it was a case of amalgamation rather a case of sale on transfer of the shares by the assessee company to SAIC Group, USA. So, the findings of the AO/DRP that the retention bonus expenditure are amalgamation expenses are based upon surmises only.

37. DRP in order to ascertain whether the payment of retention bonus actually entail any extra expenditure by the assessee as compared to the earlier years and succeeding years called upon the assessee to provide the details of the employee cost and total opening cost for the financial year 2005-06 to financial year 2010-11, which has been supplied by the assessee company, which is reproduced for ready reference as under :—

“7.3 We have considered the submissions of the assessee. High rate of attrition of employees in software industry is a very common feature. As per the NASSCOM Report available on website http://www.dnb.co.in/TonIT 08/overview.asp, Major players in the Indian software industry – Tata Consultancy Services TCS), Infosys Technologies, and Wipro- are currently witnessing high attrition rates. TCS reported an attrition rate of 11.5% – up from 10.6% a year ago; the attrition rate at Infosys was 13.17% in FY07 – higher than 11.2% recorded in FY06; the rate at Wipro witnessed a surge to 17.4% as against 14.6% during the previous fiscal, in its global IT services and product business That is why the payment of various incentives to retain the employees such as Employees Stock Option (ESOP) and payment of retention bonus is a very common HR strategy to ensure continuity and retention of talent in the company. By paying such incentives, the company saves a lot of expenditure which it would have otherwise required to spend on the training and recruitment of new employees. All software company have to give such incentives to its employees in order to retain them. In order to ascertain that whether the payment of retention bonus actually entailed any extra expenditure by the assessee as compared to the earlier years and subsequent years, the assessee was requested by this panel to provide the details of the employees cost and the total operating cost for the F.Y.2005-06 to F.Y.2010-11. The details filed by the assessee vide letter dated 23.08.2012 are as follow.

Trend of employee cost to total operating cost
Financial Year Employee Cost Total Operating Cost Employee cost as a percentage to total operating cost
2006-07 149,200,190 222,227,392 67.14%
2007-08 280,561,911 411,874,588 68.12%
2008-09 557,348,550 774,705,588 71.94%
2009-10 562,674,852 787,496,860 71.45%
2010-11 476,350,112 714,427,011 66.68%”

38. On the basis of material available on record, ld. DRP came to the conclusion that there is no substantial increase in the employee cost as a proportion of total operating cost as compared to the earlier years i.e. it has increased from 67.14% in the previous financial year to 68.12% in the financial year under assessment which is insignificant amount to have any substantial effect on the profit margin of the company.

39. Ld. DRP also noticed that retention bonus was payable over next three years and now in the year under assessment alone. Ld. DRP returned self contradictory findings that on the one hand, it is observed that the payment of retention bonus and allotment of ESOPs is very common feature in software industry and therefore such cost would be embedded in the employee cost of comparable also and on the other hand, ld. DRP observed that retention bonus paid to the employee in order to retain them for future is not in the nature of normal business expenditure but an expenditure resulting into enduring benefit to the company.

40. Ld. AR for the assessee also contended that the retention bonus paid to the employees of the erstwhile company falls under the definition of salaries u/s 15 of the Act.

41. For facility of reference, section 15 of the Act is reproduced as under :—

’15. The following income shall be chargeable to income-tax under the head “Salaries”—

(a) any salary due from an employer or a former employer to an assessee in the previous year, whether paid or not;
(b) any salary paid or allowed to him in the previous year by or on behalf of an employer or a former employer though not due or before it became due to him;
(c) any arrears of salary paid or allowed to him in the previous year by or on behalf of an employer or a former employer, if not charged to income-tax for any earlier previous year.

Explanation 1.—For the removal of doubts, it is hereby declared that where any salary paid in advance is included in the total income of any person for any previous year it shall not be included again in the total income of the person when the salary becomes due.

Explanation 2.—Any salary, bonus, commission or remuneration, by whatever name called, due to, or received by, a partner of a firm from the firm shall not be regarded as “salary” for the purposes of this section.’

42. So, when the retention bonus has been paid by the assessee company to the erstwhile employees of SCICOM in order to ensure the smooth functioning of the business to arrest the attrition rate prevalent in the software industry, it would certainly enhance the profitability of the assessee company. So, we are of the considered view that payment of retention bonus made by the assessee company partakes character of salary payable to its employee for the business purposes and has to be treated as revenue expenditure. Had the employees of erstwhile company not been retained by the assessee company its business would have adversely affected and this fact goes to prove that the retention bonus was paid as an incentive to the employee, which is salary as per Explanation 2 to section 15 of the Act, and is a business expenditure not creating any enduring benefit. Since assessee company had undisputedly paid the retention bonus before filing the return of income of the relevant assessment year these expenditure are entitled to be allowed u/s 37 of the Act. So, we hereby determine ground no.4 in favour of the assessee company.

43. Now, coming to TP grounds specifically raised by the assessee company, during the year under assessment, assessee company was engaged in the profession of software development services to its group company and has entered into international transactions with its AE to the following effect :—

No. Nature of transactions Method Value of transaction
1. Provision of Software Development services TNMM 404,411,559
2. Cost Reimbursement paid TNMM 4,972,708
3. Reimbursement received CUP 10,349,580

44. Assessee company by applying Transactional Net Margin Method (TNMM) in order to benchmarking its international transaction computed its margin at 12.08% as against mean operating margin of the comparable selected by it at 13.74%.

45. However, TPO by making fresh search on the basis of current year data only i.e. financial year 2007-08 and by applying different sets of filters chosen 10 comparables arrived at arithmetic mean OP/OC margin of comparables at 26.79% and computed ALP of software development services provided by the assessee company to its AE as under :—

1. Operating Cost 435,559,139/-
2. Arms length margin 26.79% of the OC
3. Arms length price (ALP) 552,245,432/-
4. Price received by the assessee 461,624,534
5. Adjustment proposed by TPO {(3) – (4)} 90,620898

46. Undisputedly, TNMM is the most appropriate method applied by both the assessee company as well as TPO in this case for benchmarking the international transaction.

47. Ld. AR for the assessee to cut short the controversy as to the benchmarking the international transaction undertaken by the assessee restricted its argument for inclusion of two comparables, namely, M/s. Aarman Software Private Limited and CG-VAK Software & Exports Limited otherwise rejected by the TPO as well as ld. DRP and for exclusion of Kals Information System Ltd. otherwise accepted by the TPO/DRP, which are discussed as under:-

Aarman Software Private Limited

48. TPO as well as DRP have rejected this company as comparable on the sole ground that its annual report for the year ending March 2008 is not available in the public domain. However, ld. AR brought on record the annual report of this comparable company lying at page 799 to 812 of Volume IV of the paper book, which fact has not been controverted by the ld. DR. So, we are of the considered view that when functional dis-similarity between the assessee company vis-à-vis comparable company is not in dispute, the TPO is required to reconsider this comparable for benchmarking the international transaction. So, the matter is ordered to be restored to the TPO to decide afresh after providing an opportunity of being heard to the assessee company.

CG-VAK Software & Exports Limited

49. Ld. TPO rejected this company as a comparable on the ground that it fails employee cost filter; that employees cost should be more that 25% of the total cost whereas assessee for benchmarking international transaction applied the filter of employees cost more than 25% of the total sales. However, assessee company proved on record that employees cost (cost of service) as percentage of the total revenue of the company is 75.55%. During the course of argument, ld. AR for the assessee has fairly conceded that filter of employees cost more than 25% of total cost is to be applied in this case.

50. Assessee brought on record profit and loss account for the year ending 31.03.2008 lying at pages 771 to 775 wherein in column no.15 cost of services has been duly described. When the filter of employees cost more than 25% of total cost is to be applied of cost of services described in column no.15 at page 774 of Volume IV of paper book, all the cost of services are to be treated as salary and this comparable company qualifies for inclusion in the final list of comparables. So, we are of the considered view that this issue is again required to be reconsidered by the TPO by taking into account the cost of services while applying the filter of employees cost of more than 25% of total cost. So, we hereby restore the issue to the TPO to decide afresh by providing opportunity of being heard in the light of the observation made herein before.

Kals Information System Ltd.

51. This company has been accepted as a comparable by the TPO but the assessee has opposed its inclusion on the ground that its segmental margin having inconsistency in segmental information and P&L account for financial year 2007-08 has been used without providing an opportunity of being heard to the assessee. Ld. DRP by accepting the contention of the assessee recomputed the margin of this company at 13.92% after allocating in allocated operational expenses in proportion of revenues. But, undisputedly, the directions issued by the DRP have not been complied with. So, the mater is required to be determined afresh by the TPO in the light of the unchallenged observations made by the DRP by providing an opportunity of being heard to the assessee company.

Working Capital Adjustment

52. The ld. AR for the assessee while relying upon the provisions of Rule 10B(1)(e) read with Rule 10B (3) contended that working capital adjustment should be made on reasonably accurate basis. DRP disallowed the working capital adjustment by making following observations :—

“10. The assessee has contended that it should have been allowed working capital adjustment to account for the differences between the working capital deployed by the assessee and that of comparables. At the outset, it is made clear that for allowing any adjustment for differences in respect of functions, assets and risks etc., as a general rule, the margins of comparables are adjusted to eliminate the influence of such differences on the margins of each comparable rather than adjusting the margins of tested party, i.e., the assessee in this case. The reason is obvious that margin of tested party cannot be adjusted to bring it at par with each of the comparable because degree of difference in functions, assets and risks of each of comparable with that of the assessee differs in case of each comparable. To carry out the adjustment, the availability of relevant information to accurately identify the difference and then quantify impact of such difference is a pre-requisite. In this case, we only know the amount of working capital deployed by the comparables on the first and last day of the accounting period. We have no means to ascertain the working capital deployed by the comparables through the year. In fact, the working capital adjustment should be computed on the basis daily average of working capital deployed by the tested party and each of comparable, respectively. The assessee has taken the average of the amount of working capital deployed by the comparables on the first and last day of the accounting period to compute the working capital adjustment. It is quite probable that daily average is substantially different from the average of the amount of working capital deployed by the comparables on the first and last date of the accounting period. The adjustment for functional differences etc. is to be allowed only if it can be ascertained with reasonable accuracy which is impossible in this case because of unavailability of relevant data. Therefore, this panel endorses the proposal of the AO to disallow the working capita] adjustment claimed by the assessee.”

53. However, ld. AR contended that identical issue has been decided by the Tribunal in case cited as Qualcom India (P.) Ltd.v. Asstt. CIT [2014] 147 ITD 17  (Delhi – Trib.).

54. Coordinate Bench in the judgment cited as Qualcom India Pvt. Ltd. (supra) determined the issue of working capital adjustment to account for difference in working capital employed by assessee vis-à-vis comparable companies in favour of the assessee by making following observations :—

“41. Considering the above submissions we concur with the submission of the Ld. DR that the issue raised in ground No. 6 & 7 on account of working capital adjustment and risk adjustment depend upon the fact and circumstances of each case. But at the same time we are of the view that these factors are equally important to consider while selecting comparable companies. In the present case the assessee is engaged in the business of software development and providing marketing services, hence there is no dispute that appropriate adjustment to account for difference in working capital employed by the assessee vis-a-vis the comparable companies for software development services is required to be considered. Similarly making of suitable adjustments to account for differences in the risk profile of the assessee vis. a vis. the comparable companies for software development services is also required to be considered. Of course these adjustments on account of working capital and risk is to be made after analyzing the case of the assessee since it depends upon the facts of the case of the assessee. The request for such adjustments cannot be summarily rejected unless some analysis of the case of the assessee is made vis-a-vis comparables companies. We thus set aside the matter to the file of the Ld. TPO/AO to consider these aspect of adjustment while deciding the issue afresh vis-a-vis the comparable companies in the business of software development as discussed hereinabove in the present order of the Tribunal. It is needless to mention over here that while considering these aspects opportunity would be given to the assessee to present its case in this regard. The assessee is required to cooperate with the Ld. TPO in furnishing the details, break up, datas, etc. or any other necessary information to the satisfaction of the TPO so that reasonably accurate adjustment, if any, can be made as per Indian Transfer Pricing Law (i.e. Rule 10B (3)(iii)) on account of risk and working capital. Ground No.6 & 7 are thus allowed for statistical purposes.”

55. Identical issue has also been dealt with by the ITAT, Delhi Bench ‘E’, New Delhi in case cited as Nokia India (P.) Ltd. v.Addl. CIT [2012] 51 SOT 286  and determined the issue in favour of the assessee by returning the following findings :—

‘5.1 Thus it is the contention of the ld. counsel of the assessee that the TPO while determining the arm’s length price of the subject international transaction during assessment year 2006-07 ignored the fact the assessee has been granted the benefit of the working capital adjustment during A.Y. 2005-06 by himself and the fact the same has also been allowed by his predecessors during the transfer pricing assessment proceeding for A.Y. 2002-03 till A.Y. 2004-05 despite the constraints mentioned in the transfer pricing order. Thus, it is the contention of the assessee that there is no change in the business model of the assessee with respect to the provision of contract software development services of the assessee vis-a-vis A.Y. 2005-06, the benefit of working capital adjustment should be allowed to the assessee in the subject year under appeal as well.

5.2 Ld. counsel of the assessee has further submitted that Rules 10B(1)(e) of the Rules prescribe that at the time of application of Transactional Net Margin Method, the net profit margin needs to be adjusted to account for the difference if any between the international transaction and comparable uncontrolled transactions. The relevant text of the provisions is reproduced below for reference:

“10B Determination of arm’s length price under section 92C-(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,—

“(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;”

………”

The ld. counsel has further submitted that the Hon’ble Delhi, ITAT has also upheld the need of making working capital adjustment in following judgments.

Mentor Graphics (Noida)(P.) Ltd. v. Dy. CIT [2007] 109 ITD 101 (Delhi)
Sony India (P.) Ltd. v. Dy. CIT [2008] 114 ITD 448 (Delhi)

Thus in light of the provisions of Rule 10B(1)(e) and the Hon’ble ITAT judgments, it has been pleaded to grant the Appellant the benefit of working capital adjustment.

5.3 Ld. Departmental Representative on the other hand relied upon the order of the TPO.

5.4 The DRP in its order has not dealt with the issue properly and has held that for the sake of consistency and to protect the interest of the revenue, the adjustment made by the TPO has to be upheld.

6. We have carefully considered the submissions in light of the material produced and precedent relied upon. It is an undisputed fact that on the same set of facts and in the same business model the assessee has been provided the working capital adjustments in the preceding assessment years. Under the circumstances, in our considered opinion, it was incumbent upon the TPO to consider the same in the current year.’

56. Keeping in view the fact that the issue in question has been settled in the cases cited as Qualcom India (P.) Ltd. (supra) and Nokia India (P.) Ltd. (supra) and the fact that assessee in this case is engaged in providing software development services to its group companies and to arrive at ALP of the international transactions, the ld. TPO / DRP resorted to comparability by selecting different sets of comparable companies and after applying the various filters, the ld. TPO selected 10 comparable companies as mentioned in para 8.7 of his order, the appropriate transfer pricing adjustment can only to be made qua the international transaction undertaken by the assessee company during the year under assessment on the basis of its comparability vis-à-vis comparable companies, by providing working capital adjustment to the assessee in view of the provisions contained under Rule 10B(1)(e) also. So, we are of the considered view that the matter is required to be restored to the TPO to provide the assessee company the benefit of working capital adjustment for transfer pricing adjustment.

Ground No. 7 & 8

57. Ld. AR for the assessee stated that he does not press the grounds no.7 & 8.

Ground No. 11

58. Ground No.11 is general in nature. However, AO/TPO being quasi-judicial authorities are under legal obligation to provide an opportunity of being heard to the assessee before passing afresh order. So, this ground is determined in favour of the assessee.

Ground No. 12

59. When, undisputedly, the ld. DRP has directed to treat the forex fluctuation gains/loss on support sale as an export item while comparing the assessee company with comparable companies and no appeal has been filed against the said directions, TPO is under legal obligation u/s 144 C (10) & (13) to implement the DRP’s direction. So, ground no.12 is determined in favour of the assessee.

Ground No. 13 & 14

60. Grounds No.13 & 14 are consequential, hence needs no separate discussion.

61. In view of what has been discussed above, we hereby partly allow the present appeal for statistical purposes.

Leave a Reply