ORDER
Vimal Gandhi, President
1. This appeal by the taxpayer for the Asstt. Year 2002-03 (F.A.2001-02) is directed against the order of Commissioner of Income Tax(Appeals)[in short CIT(A)] New Delhi dated 3.3.2006. The main dispute pertains to adjustment/addition of INR 1,45,73,857 in the income of the taxpayer by the revenue authorities on account of determination of arm’s length price (ALP) for software services provided to its Associated Enterprises(AE). The deduction claimed by the taxpayer under Section 10A of the Income Tax Act but denied by the tax authorities is also subject matter of dispute in appeal.
2. The facts in short compass, the taxpayer, a domestic company incorporated on Feb.27, 1998 under the Indian Companies Act is the wholly owned subsidiary of IKOS Systems Inc., a company incorporated in USA and engaged in the business of software development and also rendering marketing systems services to the parent company. The taxpayer filed its return of income for the year under consideration on October 31, 2002 declaring total income at INR 3,99,080/- for the F.A.2001-02. The income disclosed included profit from export of computer software to its parent company for which deduction under Section 10A was claimed.
2.1 The taxpayer appellant as noted earlier is a software development support service provider. However, software are developed only as instructed by its parent AE. It does not create/develop/sell software products and packages. The software developed by the appellant is used by the parent AE in-house for integrating the same with other software components developed by the parent AE itself. The whole software in turn supports the hardware manufactured by the parent, and sold as a package in the open market by the parent AE. Therefore the appellant’s business is limited to providing services of software development support.
3. The accounts and auditor’s report of the taxpayer showed that the taxpayer had carried the following transaction with its associated enterprises (AEs):
Sl. No
International Transactions(IT) With IKOS SYSTEMS
USA
Book value of the International Transactions
1.
Export of Software Development Services
88,866,320
2.
Export of Marketing Support Services
3,436,194
4. The taxpayer in order to show that transactions with AEs were arm’s length transactions selected Transactional Net Margin Method (TNMM) as the most appropriate method under Section 92C of the Income Tax Act and further justified the price charged for services as arm’s length price with following certificate in the auditor’s report:
Based on the study, the arithmetic mean of three year weighted average margins for financial years ended March 31, 2000, March 31, 2001 and March 31, 2002 to the extent available of broadly comparable independent companies calculated using Net Cost Plus Margin as the profit level indicator was compared by the assessee with its three year weighted average margin for financial years March 31, 2000, March 31, 2001 and March 31, 2002. In the opinion of the assessee its Net Cost Plus Margin, having regard to economic and commercial factors, appears to be arm’s length as provided under Section 92C of the Act. Accordingly, the amounts received/receivable in respect of the above transactions have been computed by the assessee having regard to the arm’s length price.
5. The Assessing Officer referred the question of computation of Arm’s length price of International transactions to Transfer Pricing Officer (TPO). The TPO accepted that export of marketing support services have been rendered at the arm’s length price and, therefore, the amount disclosed by the assessee as per books needed no adjustment. In the above situation, we thought it appropriate not to make any comment on the transaction relating to export marketing support services. The discussion hereafter is confined to other transaction of export of software development services.
6. Export of software development services, has been shown at total value at INR 88,866,320 for the entire year. Taxpayer has further explained that software was supplied by the taxpayer to its parent company and price was worked out at the rate of US$ 180 per man day. The transactions were priced on average and should have been compared with either an internal comparable, uncontrolled price (internal CUP) or an external comparable uncontrolled price (external CUP). The parent company did not receive similar services from any independent third party, nor the taxpayer provided such services to any uncontrolled party and, therefore, internal CUP did not exist. Even external CUP was not available. Average billing rates (man days/ man month rate) would vary from technology to technology, from one domain to another and differ according to hierarchy levels, contractual terms, market conditions, geographies and it would not be possible to make adjustment for above factors as also for economic conditions. Above all, all the relevant information is not available in public domain. Therefore, in the circumstances and situation mentioned above, average bill rate, according to the taxpayer was the correct representation of a CUP. The taxpayer having regard to the above worked out net margin of software development transaction INR 88,866,320 (total turnover of Rs. 9,23,02514) in ratio of total cost at 6.99%.
7. In order to show that above net margin was fair and reasonable and represented arm’s length price, the taxpayer claimed it has taken the following steps. It carried its own functional, asset and risk (FAR) analysis and of several other independent companies carrying on business of development of software. The taxpayer was taken as the tested party. In it’s written submissions the taxpayer further claimed as under:-
Based on the functional analysis and understanding of the international transactions with associated enterprises and the available data of comparable companies, the Transactional Net Margin Method (TNMM) using net profit margin based on costs (NCP) as a profit level indicator(PLI), was selected to be the most appropriate transfer pricing method to evaluate these transactions.
12. On the question of Search for comparable companies (Refer para 4.1.4. page No. 89 to 93 of the paper book, the taxpayer submitted as under:
The objective of the search for comparable companies was to identify from publicly available data, a group of independent companies that undertake software development just as the appellant company.
The PROWESS database was employed to identify the potential comparable companies. PROWESS contains financial data of over eight thousand largely publicly traded Indian companies. The idea is collected from annual/quarterly results, government reports and other sources.
The search under this database was structured to cover the ‘Company’s Main Activity’ as well as ‘Products Manufactured/traded etc.’. All the companies classified under the following categories were considered:
– Computer software; and
– Software service and consultancy.
This search yielded a list of 373 companies.
8. Thereafter, the taxpayer carried quantitative screening and eliminated 32 companies as their manufacturing sales to sales ratio was more than 25%. Further, 82 companies were eliminated as trading sales to sales ratio was more than 25%. This was done as the taxpayer is only engaged in provision of services and is not engaged in any manufacturing or trading activity. The description of the search relating to eliminating of above 114 companies is available at pages 113 to 115 of the paper book. The taxpayer thereafter performed a qualitative review of remaining 259 companies. From product profile, director’s report, background information and financial statements, taxpayer tried to find companies having similar functional profile to that of taxpayer. On above screening, the assessee eliminated 249 companies as those companies were dealing with different product or were carrying different functions or were involved in controlled party transactions or sale of operation was very low or suffered operational loss of more than 10%. In respect of some, insufficient information was available in public domain regarding their products, functions or financial position. The reasons for elimination of 243 companies are available at page 9 of the paper book filed by the taxpayer.
9. The taxpayer was thereafter left with 16 companies with profit level indicator for financial years 2000 and 2001:
S.No.
Name of the Company
2000
2001
1.
Top Media Entertainment
9.68
(12.12)
2.
Kushagra Software
(0.56)
0.0
3.
Shine Computech
3.69
5.16
4.
M Y M Technologies
11.44
0.93
5.
Luminaire Technologies
12.70
6.64
6.
O C L Informatics
17.07
6.67
7.
Telesys Software
39.81
4.34
8.
C S Software Enterprise
22.98
8.54
9.
V G L Softech
8.89
15.38
10.
Integrated Hitech
14.67
12.37
11.
Zigma Software
45.79
1.63
12.
Visu Cybertech
5.21
24.74
13.
V J I L Consulting
21.34
17.45
14.
Sark Systems India
20.56
30.77
15.
Fore C Software
47.44
22.12
16.
Pentagon Global Solutions
36.99
32.24
Arithmetic mean
13.41
10. Since the NCP (Profit Margins) of above companies as per average arithmetic mean NCP) was 13.41% against 11.07% earned by the taxpayer in the relevant assessment years, it was claimed that taxpayer carried international transaction at Arm’s Length if proviso to Section 92C(2) of I.T.Act permitting variation of +/- 5% is kept in mind. It was accordingly claimed that international transaction carried by assessee was at arm’s length.
11. The Transfer Pricing officer refused to accept above claim of the taxpayer. He raised certain objections on the uncontrolled comparable selected by taxpayer in its computation of Arm’s Length Price. The TPO also objected to use of data for years other than the financial year involved in question. In order to meet the objections of the T.P.O., the taxpayer on 8.11.04 gave fresh computation with reference to the following 16 companies and worked out from relevant data the average net cost margin for F.A. 2001-02 at 3.07% against 6.99% disclosed by the appellant. The detail is as under:
S.No.
Company Name
Net cost plus Margin
1.
MYM Technologies
4.81%
2.
Kushagra Software
-0.49%
3.
VJIL Consulting
5.24%
4.
Integrated Hitech
-1.04%
5.
Zigma Software
16.38%
6.
Sark Systems
30.00%
7.
Pentagon Global Solution
2.43%
8.
Shine Computech
0.47%
9.
Fore C Software
5.76%
10.
Visu Cybertech
-2.76%
11.
CS Software
-25.12%
12.
OCL Informatics
4.44%
13.
Luminaire Technologies
0.00%
14.
Telesys Software
2.88%
Average Net Cost plus Margin
3.07%
11. Two companies were considered and excluded as per the following note:
Note: VGL Softech has not been included in the set as it is a startup company. Further, Top Media Entertainment has also been excluded as it does not have financials updated for March 2002.
12. The TPO in its order dated 18.3.05 has referred to above details. He has however observed that the taxpayer did not carry any fresh search for comparables and has merely reworked the figures of same comparables as used in the audit report. Earlier, on 20th January 2005, the TPO had asked the taxpayer to explain as to why companies having a) substantially low turnover; b) companies engaged primarily in manufacturing activities and c) companies with low employees cost should not be eliminated from the comparables taken into account by the taxpayer. The TPO ultimately listed the following companies for elimination from comparison in Para 7.5 of its order:
Name of the company
Reason for elimination
Kushagra Software Ltd.
Manufacturing concern
Integrated Hitech Ltd.
Low turnover
Fore C Software Ltd.
Low employee cost
Luminaire technologies
Ltd.
Low turnover
Telesys Software Ltd.
Low employee cost
Pentagon Global Solutions Ltd.
Low employee cost. Engaged in manufacturing activity
OCL Informatics Ltd.
Low turnover
13. The TPO thereafter claimed to have carried independent search of comparable from the PROWESS and CAPITALINE database and Nasscom directory and worked out the average operational profit for comparison at 26.94% with the following remarks and details in para 7.6 of his order:
The search was conducted for the companies engaged in software development, having turnover between Rs. 50 lakhs to Rs. 100 crores, having employee cost of more than 10%, not having manufacturing and trading sales of more than 10% of total sales and not having any related party transactions. After applying such filters, the following set of companies was identified as comparables:
Name of the company
Operational Profit %
Blue Star Infotech Ltd.
27.18%-
Ideaspace Solutions Ltd.
20.69%
Integrate Hitech Ltd.
3.16%
NIIT Gis Ltd.
28.80%
Quintegra Solutions Ltd.
37.89%
Sark Systems India Ltd.
27.91%
Teledata Informatics Ltd.
32.99%
Average OP/TC
26.94%
14. In response of notice dated 27.1.2005 of the T.P.O. on above operating profit as a benchmark, the taxpayer vide its reply dated 31.1.05 raised objections as under:- 1) that all the companies selected with the exception of Sark Systems and Quintegra Solutions, have either foreign parent or subsidiary company and are most likely to have related party transactions. 2) That Quintegra Solutions is liable to be eliminated on account of difference in project profile. The TPO on above objections observed that “he was not prepared to eliminate companies having foreign parent or subsidiary company unless value of related party transactions was furnished by taxpayer”. The stand of taxpayer that the taxpayer was unable to furnish value of related party transactions as relevant information relating to year 2001-02 was not available in public domain. The TPO accepted the fact that data of relevant year was not available. However, the data of the subsequent years, according to the TPO could provide an indication of the quantum of related party transactions that might have taken place in the relevant year. Out of the companies considered for comparison, two companies namely Blue Star Infotech and NIIT Gis Limited had related party transactions in the year ended March 2004 though there was no evidence that these companies had related party transactions in the year under reference (F.A. 2001-02). It has been observed by the T.P.O. in his order that he felt “prudent to accord the benefit of doubt to the assessee that there could be a related party transaction in respect of these two comparable companies for the year under examination”. Accordingly, above two companies were excluded from the proposed list of comparable companies.
15. The TPO accordingly took other three companies for computation of average of OTC/TC as those companies did not have any related party transaction in the year 2003-04.
16. Quintegra Solutions was included in the list of comparable with following observations:
As far as the product profile of Qunitegra Solutions is concerned, the same was re-examined consequent upon the objection raised by the assessee. It is found that this company, too, is engaged in software development services and as such is a fit comparable for analysis. Moreover, transactional Net Margin Method is more tolerant to minor functional differences and is less affected by transactional differences (para 3.27 of OECD report Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, July 1995).
17. Thereafter, Arm’s Length Price of the international transaction and adjustments were worked out at Rs. 1,45,73,857 with the following remarks:
7.8 In view of the above discussions, the following list of comparable companies are finally chosen for analysis.
Name of the company
OPTC (F.Y.2001-02)
Ideaspace Solutions Ltd.
20.69%
Integrated Hltech Ltd.
3.16%
Quintegra Solutions Ltd.
37.89%
Sark Systems India Ltd.
27.91%
Teledata Informatics Ltd.
32.99%
Average OP/TC
24.53%
Hence, the arithmetic mean of operating profit over the total cost margins of the comparable companies for the financial year 2001-02 works out to 24.53%. The arm’s length price of the international transactions entered into by the assessee with its AE is worked as under:
Total cost of provision of services by the assessee:
Rs. 8,30,64,464
Margin @24.53% of the above:
Rs. 2,03,75,713
Arms length price to be charged from the AE
Rs. 10,34,40,177
7.9 In the manner discussed above the arm’s length price of the international transactions entered into by the assessee with its AE is determined at Rs. 10,34,40,177 in place of Rs. 8,88,66,320/-
7.10 Accordingly, an adjustment of Rs. 1,45,73,857/- is to be made to the income of the assessee, being the difference between the arm’s length price and the price charged by the assessee from its AE for rendering services to them.
7.11 As regards the marketing services, the assessee has relied on TNMM with Net Cost Plus (NCP) margin as PLI. On examination of the documentation and the functional analyses contained therein no adverse inference is drawn in respect of this international transaction.
Sd/-
( HIMANSHU SINHA )
JOINT COMMISSIONER OF INCOME TAX
(TRANSFER PRICING OFFICER-I),NEW DELHI
18. The taxpayer impugned above adjustment/addition on account of transfer pricing (INR 1,45,73,857) in appeal before the ld. C.I.T.(A) and vehemently challenged the report of the Transfer Pricing Officer (T.P.O.) The taxpayer also claimed that it was entitled to claim deduction under Section 10A of the Income Tax Act. The ld. CIT(A), after examining facts and circumstances of the case, upheld the finding of the Assessing Officer (A.O.) that the taxpayer was not entitled to deduction under provision of Section 10A of the Income Tax Act. The reasons which weighed with him to uphold the denial was that the unit of the assessee was an old unit in existence since the year 1998 and that in respect of this very unit, assessee had claimed and was allowed deduction in the Asstt. Year 1999-00 which was the first year of operation of the unit. The taxpayer, therefore, could not be permitted to change its claim of deduction in respect of same unit from Section 80HHE to Section 10A in subsequent years. The claim of the taxpayer was against the intention of the legislature which had clearly laid down that deduction under Section 10A with regard to export of profit was not available to old units. The ld. CIT(A) further held that the taxpayer was also not entitled to deduction under Section 80HHE in this year as mandatory requirement of the said section regarding furnishing of the auditor’s report in Form 10 CCAF along with the return of income was not fulfilled. Accordingly, ld. CIT(A) upheld the rejection of claim of Rs. 59,56,330 under Section 10A of the I.T.Act.
19. Thereafter, the ld. CIT(A) considered grievance of the assessee on account of adjustment of Rs. 1,45,73,857 representing the arm’s length price. He noted that for the current financial year 2001-02, the taxpayer had chosen Transactional Net Margin Method as most appropriate method to determine arm’s length price with operating profit margin over total cost (OP/TC) as profit level indicator (PLI). The exercise carried by the taxpayer in identifying 16 comparable companies from PROWESS and working of weighted average operating margin of taxpayer and other comparable companies was noted. The ld. CIT(A) accepted that the selection of the method i.e. TNMM as well as PLI i.e. OP/TC were found appropriate by the TPO/A.O. The ld. CIT(A) was of the view that taxpayer was not justified in taking into account data for the earlier two preceding years. In his view, only the data for the current year should have been taken into account. He has given detailed reasons in different Paras. We are not recording all reasons/details as during the course of hearing before us, ld. Representative of the taxpayer agreed that Arm’s length pricing has to be determined by taking only the data of the current year. He fairly conceded that the Special Bench in the case of Aztec International has also taken the same view and the said view has to be followed by this regular Bench. The ld. CIT(A) also rejected the claim of the Taxpayer that reference made by the Assessing Officer to the TPO under Section 92CA(1) was bad in law and, therefore, order of TPO void for want of jurisdiction. This issue was also not agitated in appeal before us as the same is covered against the taxpayer as per the Special Bench decision referred to above.
20. The ld. CIT(A) had also rejected the claim of the Taxpayer that arm’s length price determined by TPO was required to be reduced by 5% in terms of proviso to Section 92C(2) of the Act. It was contended that variation of +/- 5% has to be allowed in every case to the taxpayer while making adjustments in international transaction on account of arm’s length price in the light of mandate of proviso to Section 92C(2) of the Act. The taxpayer had also placed reliance on Instruction No. 3 dated 20.5.2003 of CBDT. Ld. CIT(A) did not find any force in these contentions. We are also not considering the finding of the ld. C.I.T.(A) on this aspect in details, as no arguments were addressed nor issue agitated before us in appeal.
21. The ld. CIT(A) further noted that TPO had carried search of comparable companies form Prowess and Capitaline databases and Nasscom Directory and identified seven companies with their performance for financial year 2001-02 as comparable companies. On further analysis, the T.P.O. had excluded two companies out of above seven companies on account of objection of the taxpayer and finally a set of five companies were chosen as comparable. The arithmetical mean of operating profit margin over total cost (OP/TC) of these companies for the relevant financial year worked out at 24.53%. On the basis of above comparable cases, cost of provisions of software development services were determined at Rs. 10,34,40,177 against Rs. 8,88,66,320 disclosed by the assessee. This way, addition of Rs. 1,45,73,857 according to the ld. CIT(A) was rightly made. As in the proceedings before the Tribunal, the ld. Representative of the taxpayer had vehemently challenged selection of comparables by the TPO, it would only be appropriate to take note of the finding recorded by ld. CIT(A) on the selection of comparable by the TPO. After noting as to what is required to be done while determining ALP by tax authorities under Section 92C/CA r/w Income Tax Rule 10B, the ld. CIT(A) upheld the assessment. His concluding observations are as under:
58. The contentions of the appellant challenging the reliability and correctness of the comparable uncontrolled transactions are, thus, found to be baseless and without any merit and the same are, accordingly, rejected. On a careful consideration of the facts and circumstances of the case and the relevant position of the law, I am of the considered view that TPO has correctly selected the set of five independent companies having comparable uncontrolled transactions for determination of arm’s length price of the international transactions and his action in this regard is, accordingly, confirmed.
59. The arm’s length price of the international transactions of export of software development services has been determined by the TPO by taking into account the arithmetic mean of operating profit margins over total cost (OP/TC) of the above five comparables independent companies having comparable uncontrolled transactions. The arithmetic mean of the OP/TC of these comparable companies was worked out to 24.53%. By applying this arithmetic mean margin of 24.53% to the total cost of provision of software development services amounting to Rs. 8,30,64,464/-, the arm’s length price in respect of international transactions of export of software development services to the AE was determined by the TPO at Rs. 10,34,40,177/-. In fact, initially there would be five arm’s length prices if OP/TC of each of above five comparable independent companies is separately applied to the total cost. Thereafter, the arithmetical mean of such five arm’s length prices shall be taken as the arm’s length price under the proviso to Section 92C(2) of the Act. The arm’s length price determined by the TPO at Rs. 10,34,40,177/- by taking the arithmetic mean of OP/TC of all five comparable companies actually represents the arithmetical mean of the arm’s length prices under the proviso to Section 92C(2) of the Act.
60. As against the arithmetic mean arm’s length price of Rs. 10,34,40,177/- determined by the TPO, the appellant had charged the transfer price from its AE only at Rs. 8,88,66,320. The price so charged by the appellant was 14.09% less than the arithmetical mean of arm’s length prices determined by the TPO. Thus, the difference between the price charged by the appellant and the arithmetical mean arm’s length price determined by the TPO exceeded the permissible variation of +/- 5%. Therefore, as discussed in detail hereinbefore, the benefit of reduction of the arithmetical mean arm’s length price up to 5% was not allowable to the appellant in such a case. Consequently, the addition on account of transfer pricing adjustment would be made for the difference between the arithmetical mean arm’s length price of Rs. 10,34,40,177/- determined by the TPO and the transfer price of Rs. 8,88,66,320 charged by the appellant. The difference between these two prices works out to Rs. 1,45,73,857/- and the same was, accordingly, added by the Assessing Officer to the total income of the appellant.
61. In view of the foregoing and on a careful consideration of the facts and circumstances of the case and the relevant position of the law, I am of the considered view that the Assessing Officer was justified in making an addition of Rs. 1,45,73,857/- to the total income of the appellant on account of difference between the arm’s length price determined by the TPO and the transfer price charged by the appellant from its AE in respect of international transactions of export of software development services and the addition so made by him is, accordingly, confirmed.
22. The taxpayer being aggrieved has impugned the order of the ld. CIT(A) in appeal before the Income Tax Appellate Tribunal(in short Appellate Tribunal). We have heard both the parties and taken into account material on record to which our attention was drawn. In the case of Aztech Software & Technology Services Ltd. v. ACIT 249 ITR (AT) 32, the Special Bench of five members considered the statutory provisions of Income Tax Act and Rules relating to Transfer Pricing and held as under:
Computation of the arm’s length price is essentially a factual exercise. Each case depends on its own peculiar facts and circumstances. In certain cases where an identical or almost similar uncontrolled transaction is available for comparison determination of the arm’s length price is an easy task. However, it is not so in most transactions and rarely is one able to locate an identical transaction. In such cases the arm’s length price is determined by taking the results of a comparable transaction in comparable circumstances and making suitable adjustments for the differences.
The fundamental requirement, in any of the methods selected, is the selection of “comparables, for benchmarking international transactions. This selection of a comparable should be based on functional, asset, and risk analysis of both the parties and transactions. Whatever methodology is chosen for the purpose of determination of the arm’s length price under Section 92C, these criteria, as specified in the Act and the Rules have to form a basis of judging the comparability.
Thus, there should be a proper analysis of such transactions with respect to the functions performed, the assets employed and the risk assumed by the respective parties with reference to the transaction in question. This can be termed as functional, asset, risk analysis, i.e., FAR analysis. All the three ingredients of FAR have a direct bearing on the pricing of products/services. The provision also provides scope for carrying out adjustments in case where there are some differences or variations to make two transactions commercially comparable, for the purpose of benchmarking. The adjustments are suggested to achieve the object of testing and trying to see if both the parties or/and the transactions are similar or nearly similar.
23. In the case of DIT (International taxation) v. Morgan Stanley 292 ITR 416, the Hon’ble Supreme Court after considering relevant Indian regulations on transfer pricing made some pertinent observations which are noted as under:
The object behind enactment of transfer pricing regulations is to prevent shifting of profits outside India.
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The impugned ruling is correct in principle in so far as an associated enterprise, that also constitutes a P.E., has been remunerated on an arm’s length basis taking to account all the risk/taking functions of the enterprise.
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where the transaction between the two are held to be at arm’s length basis taking into account all the risk-taking functions of the multinational enterprise. In such a case nothing further would be left to attribute to the P.E. The situation would be different if the transfer pricing analysis does not adequately reflect the functions performed and the risks assumed by the enterprise. In such a case, there would be need to attribute profits to the P.E. for those functions/risks that have not been considered.
24. It is true that “transfer pricing” is not an exact science, evaluation of transactions through which the process of determination is carried in an art where mathematical certainty is indeed not possible and some approximation cannot be ruled out, yet it has to be shown that analysis carried was “judicial” and was done after taking into account all the relevant facts and circumstances of the case. Minimum requirement is to prima facie show that controlled international transaction was properly examined, comparable and arms’ length price fixed objectively, honestly and in a bona fide manner as required by the statutory regulations. The requirement of the statutory regulation has been thoroughly discussed by the Appellate Tribunal in the case of Aztech Software (supra), but in order to dispose of this appeal, these are reiterated here:
25. The comparability of an international transaction i.e. uncontrolled transaction and a controlled transaction is to be judged under Rule 10B(2) 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.
Further caution required to be adopted while looking to the differences between controlled and uncontrolled transaction is provided in Sub-rule (3) of Rule 10B which is as under:
(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.
Further “Rule 10B(1)(e) of Income Tax Act providing for determination of Arm’s Length Price under Section 92C required that following steps are to be taken while applying TNMM after selection and evaluation of controlled transactions. It is as under:
(e) transactional net margin method, by which, –
(i) the net profit margin realized by the enterprise from an international transactions 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 realized 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 realized 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.
As noted in the case of Aztech Software (supra) “rarely one is able to locate an identical uncontrolled transaction”. The Arms’ Length Price is determined by taking result of a comparable transaction in comparable circumstances and by making suitable adjustments for the differences.
26. The first step in the determination of Arms Length Price is to analyse the specific characteristics of the controlled transaction whether it relates to transfer of goods, services or intangible. Without proper study of specific characteristics of controlled transaction, no meaningful comparison or location of comparable is possible. For example, a mere consideration that controlled transaction relates to “software supply” is not sufficient as there are hundreds of softwares with different characteristics which materially affect their open market value. The characteristics that are required to be considered include in case of transfer of tangible property, the physical feature of the property, its quality, reliability and availability (supply). In case of provisions of services, the nature and extent of services and where tangible property is involved for comparison, the form of transaction. To put it in other words, all the characteristics of the controlled transaction which are likely to affect its open market value must be taken into account. The study should include analysis of functions, risk and assets of the controlled transaction for correct location of similar or nearly similar characteristics in uncontrolled transactions. Specific characteristics are necessary to carry search of similar comparable with similar characteristics.
27. After the selection of the comparables, best method of determining Arms’ Length Price is selected. Thereafter, functional analysis is carried to identify functions, risk and assets of uncontrolled transactions and comparison is carried with characteristics of the controlled transaction. This is necessary to find whether comparable selected are really comparable and reliable. Comparison based on functional analysis include economically significant activities and responsibilities undertaken or to be undertaken by the independent and associated enterprises. The structure and organization of the group and more particularly the judicial relationship between different entities of same group are to be seen. The function that need to be identified while carrying comparison as per OECD guidelines include design, manufacturing, assembling, research and development, servicing, purchasing, distribution, marketing, advertising, transportation, financial and management activities. It is also necessary to examine as to what is the principal function of the entities. The analysis of comparison should consider total assets employed and assets used to earn profit. The risk assumed by respective parties is a very important consideration. It is a simple principle of economics that the greater the risk, the greater the expected return (compensation). If there are material and significant differences in the risk involved, then the comparable identified are not correct as appropriated adjustments for differences in such cases are not possible. Therefore, while performing searches for potential comparable companies, not only turnover and operating profit but functions performed and risk profile are also to be considered. However, it can always be shown on the given facts of the case that comparable found are similar or almost similar to the controlled transaction and no adjustments are needed. It is useful to see the level of intangible assets in comparable to an appropriate base. Depending on facts of the case, final set of comparables may need to eliminate differences by making adjustments for the following:
(a) working capital
(b) adjustment for risk and growth
(c) adjustment of R&D expenses
27.1 The risk not only due to human resources, infrastructure and quality which are normally taken into account yet more significant risks like market risk, contract risk, credit and collection risk and risk of infringement of intellectual property are being ignored here. In most of the comparable analysis carried in India, the latter type of risk are not being taken into consideration although these can lead to major difference in Market Value of transactions.
27.2 The European tax authorities are reluctant to accept “adjustments” because adjustments necessarily involve consideration of question whether they are appropriate or not and therefore it is always better to find comparable requiring the least or no adjustment. The position in India as per Indian regulations on the subject has been noted earlier. If there are differences which can be adjusted, then adjustments are required to be made. If the difference between the companies are so material that adjustment is not possible, then comparables are required to be rejected.
27.3 Further in the analysis numerous ratio are applied, depending on the specific of the comparables. The search may include the following:
Inventory/sales; operating assets to total assets, fixed assets to total sales, fixed assets to number of employees, operating expenses to sale, cost of sales.
28. In the present case, there is agreement between the parties that Transaction Net Margin Method for determination of Arm’s Length Price was the most appropriate method. It was attempted to be applied by both the parties.
29. The ld. CIT(A) in para 15 of the impugned order has specifically agreed and has recorded as under:
The selection of method i.e. TNMM, the PLI i.e. the OP/TC were found to be appropriate by the Assessing Officer.
30. On facts, we are not inclined to go into the issues not disputed before us. It is part of the agreement between the parties that all companies selected as “comparable” had operated from India in supply of softwares etc. We therefore proceed to decide the dispute on above accepted premises. The dispute is confined to selection of reliable and authentic comparable.
31. It is the case of the taxpayer that if proper selection is made by applying proper filter (FAR), the PLI of comparables would be 3.61% as against 6.99% of the taxpayer and, therefore, Arms Length principles are fully satisfied and no adjustments need in the international transaction carried by the taxpayer with its AE. The T.P.O., on the other hand, has worked arithmetic means of OP/TC at 24.53% as noted earlier and determined Arms’ Length Price of international transaction at INR 10,34,40,177 leading to addition of INR 1,45,73,857.
32. It is undisputed and fully borne from record that tested party was developing specific software for its parent company, the software developed by the taxpayer was used by parent in-house for integrating the same with other software components developed by itself. The whole software, in turn, supported the hardware manufactured by the parent and sold as a package in the open market. The role of the tested party has been that it is a contract software development support service provider. It is a captive company.
33. Most of the business risk such as contract risk, market risk, credit risk, warranty risk, price risk etc. were essentially borne by parent AE. Normal foreign exchange risk was borne by the taxpayer.
34. The Intellectual Property Right (IPR) was owned by parent AE in all intangibles that were provided to the taxpayer for carrying out software development services. The taxpayer emphatically and rightly claimed which is not disputed that it does not own any valuable intangibles, the parent AE had provided necessary intangible such as software and other proprietary tools and process to carry out the software development. All intangibles including discoveries, improvement, inventions and trade secrets conceived or reduced to practice were the sole and exclusive property of the Parent AE. The taxpayer only maintained and deployed necessary human resources and infrastructure for development of software. The above stated specific characteristics were required to be considered under the Indian Regulation Rule 10B noted above and even under OECD guidelines. However, above characteristics of controlled transactions were evidently not kept in mind by the T.P.O. to find comparable and, therefore, order of T.P.O./basis of adjustments is not sustainable on above grounds. The TPO committed several minor and major errors while computing the so-called Arms’ Length Price.
35. In the first place, while screening and filtering for comparables, he took into account companies which were dealing with their related companies either as subsidiaries or as parent companies. Thus, controlled transactions were taken into account which is against the very basics of the transfer pricing guidelines. When it was pointed out by the assessee in objection dated 31.1.05 (refer para 7.51 of the TPO’s order), the TPO put on the assessee to “bring on record any related party transactions of companies chosen as comparables”. The assessee then pointed out that the above data in Jan., Feb. 2005 for financial year 2001-02 was not available in public domain base PROWESS and CAPITALINE and, therefore, could not be produced. This position is admitted by T.P.O. in his order. The approach of the ld. T.P.O. cannot be approved, after all T.P.O. was carrying judicial or quasi-judicial proceeding. After accepting that the data for financial year 2001-02 was not available at that relevant time in 2005, the TPO considered data of two years later i.e. for financial year 2003-04 and found that two companies namely Blue Star Infotech Ltd. and NIIT Gis Ltd. had related transaction and, therefore, these two companies were excluded from the list of comparables selected by the TPO. As regards other selected companies, these were included in the list as related party transactions were not found in the financial year 2003-04. The T.P.O. presumed that related party transactions were not carried in F.Y.2001-02 without considering relevant data for F.Y. 2001-02 as is clearly admitted hereinafter. The T.P.O. has observed:
The other three companies, proposed to be chosen as comparables did not have any related party transaction in the year 2003-04. Hence, under the same premise, it has been presumed that these companies did not have any sizeable value of related party transaction in the year under examination and accordingly these comparables were retained for analysis and benchmarking.
35.1 From the above, three facts are clearly established: 1) That in selecting comparables, the TPO chose transactions which included transactions with related parties; 2) The observations that he had carried search and selected parties “not having any related party transaction” made in para 7.6 of order are hollow and untenable; 3) T.P.O. has used data for financial year 2003-04 to verify transactions of financial year 2001-02 after prohibiting the taxpayer to use data for any year other than F.A. 2001-02. The conclusion and the inference that as in data for financial year 2003-04, there was no related transaction, a presumption can be drawn that even in the financial year 2001-02 i.e. two years earlier, there were no inter-party transactions. Such inferences and presumptions are not authorized and cannot be accepted. Assessment under the Act is a judicial act and must be based on cogent material, not on unsound presumption. There is no nexus between the material available on record and the conclusion drawn. Further one wonders and finds no answer to the pertinent question; if data for F.Y.2001-02 was not available in the year 2005, as is the admitted position, then how and wherefrom transactions with features as mentioned in para 7.6 of order were found? On facts, we hold that TPO carried search which had serious defects materially affecting the determination of Arms’ Length Price and his order can not be accepted as legally correct.
35.2. Further there is contradiction in the approach of TPO; whereas he rightly insisted in the light of Rule 10B(4) that only data for the financial year was relevant but for his own use, he has taken into account data for financial year 2003-04 i.e. relating to two years later.
35.3 One more problem with the order of T.P.O. is that he did not take into account specific characteristics of the controlled transaction while searching for comparable and failed to apply FAR test to controlled or potentially comparable uncontrolled companies/transactions.
36. In the present case, specific characteristics of services provided, functions performed, assets employed and risk assumed are reiterated as under:
The taxpayer as noted above is providing software development support services to its parent AE as per the instructions of its parent company. It does not create/develop/sell software products and packages. The software developed by the appellant is used by the parent in-house for integrating the same with other software components developed by the parent AE itself. The appellant business is therefore limited to providing software development support services. Further, taxpayer assumes low business risks and employs only routine tangible assets i.e. it does not develop or own any valuable or non-routine intangibles.
36.1 There is no dispute about above characteristics or FAR of the taxpayer. However, above characteristics do not appear to have been taken into account by the ld. TPO while undertaking screening and elimination of companies. Ultimately, when five companies were selected by the TPO for comparison, the material on record does not show that TPO cared to know the size of those companies. There is no mention of the characteristics of companies adopted and whether those companies had any intangible properties or what was the ratio of fixed and operating assets. Whether those companies were also low risk companies like that of the taxpayer. Even on prima facie consideration of the companies selected, it is found that PIL variation between them is very wide throwing doubt on correctness of analysis.
36.2 In TPO’s views, the Transaction Net Margin Method being more tolerant to minor functional differences, there was no need to carry functional and other analysis to find difference in transactions. For this purpose, he relied upon para 7.27of OECD report of July 1995. In our opinion, para 3.27 has been taken by TPO out of context. In the Guidelines the strength and weaknesses of the Transaction Net Margin Method has been compared with other methods and one strong point stated has been overemphasized by the T.P.O. This is what has been stated in para 3.27:
3.27 One strength of the transactional net margin method is that net margins (e.g. return on assets, operating income to sales, and possibly other measures of net profit) are less affected by transactional differences than is the case with price, as used in the CUP Method. The net margins also may be more tolerant to some functional differences between the controlled and uncontrolled transactions than gross profit margins. Differences in the functions performed between enterprises are often reflected in variations in operating expenses. Consequently, enterprises may have a wide range of gross profit margins but sill earn broadly similar levels of net profits.
36.3 Extracts from other Paras 3.29, 3.34, 3.35, 3.37 and 3.39 of the same guidelines would clearly show that the inference drawn is one-sided. These paras are as under:
3.29 There are also a number of weaknesses to the transactional net margin method. Perhaps the greatest weakness is that the net margin of a taxpayer can be influenced by some factors that either do not have an effect, or have a less substantial or direct effect, on price or gross margins. These aspects make accurate and reliable determinations of arm’s length net margins difficult. Thus, it is important to provide some detailed guidance on establishing comparability for the transactional net margin method, as set forth in Sub-section c)(1) below.
3.34 Prices are likely to be affected by differences in products, and gross margins are likely to be affected by differences in functions, but operating profits are less adversely affected by such differences. As with the resale price and cost plus methods that the transactional net margin method resembles, this, however, does not mean that a mere similarity of functions between two enterprises will necessarily lead to reliable comparisons. Assuming similar functions can be isolated from among the wide range of functions that enterprises may exercise, in order to apply the method, the profit margins related to such functions may still not be automatically comparable where, for instance, the enterprises concerned carry on those functions in different economic sectors or markets with different levels of profitability. When the comparable uncontrolled transactions being used are those of an independent enterprise, a high degree of similarity is required in a number of aspects of the associated enterprise and the independent enterprise involved in the transactions in order for the controlled transactions to be comparable; there are various factors other than products and functions that can significantly influence net margins.
3.35 The use of net margins can potentially introduce a greater element of volatility into the determination of transfer prices for two reasons. First, net margins can be influenced by some factors that do not have an effect (or have a less substantial or direct effect) on gross margins and prices, because of the potential for variation of operating expenses across enterprises. Second, net margins can be influenced by some of the same factors, such as competitive position, that can influence price and gross margins, but the effect of these factors may not be as readily eliminated. In the traditional transaction methods, the effect of these factors may be eliminated as a natural consequence of insisting upon greater product and function similarity.
3.37 Assume, for example, that a taxpayer sells top quality video cassette records to an associated enterprise, and the only profit information available on comparable business activities is on generic medium quality VCR sales. Assume that the top quality VCR market is growing in its sales, has a high entry barrier, has a small number of competitors, and is with wide possibilities for product differentiation. All of the differences are likely to have material effect on the profitability of the examined activities and compared activities, and in such a case would require adjustment. As with other methods, the reliability of the necessary adjustments will affect the reliability of the analysis. It should be noted that even if two enterprises are in exactly the same industry, the profitability may differ depending on their market shares, competitive positions, etc.
3.39 The transactional net margin method may afford a practical solution to otherwise insoluble transfer pricing problems if it is used sensibly and with appropriate adjustments to account for differences of the type referred to above. The transactional net margin method should not be used unless the net margins are determined from uncontrolled transactions of the same taxpayer in comparable circumstances or, where the comparable uncontrolled transactions are those of an independent enterprise, the differences between the associated enterprises and the independent enterprises that have a material effect on the net margin being used are adequately taken into account. Many countries are concerned that the safeguards established for the traditional transaction methods may be overlooked in applying the transactional net margin method. Thus where differences in the characteristics of the enterprises being compared have a material effect on the net margins being used, it would not be appropriate to apply the transactional net margin method without making adjustments for such differences. The extent and reliability of those adjustments will affect the relative reliability of the analysis under the transactional net margin method.
37. It is clear that even when TNMM method is applied to determine arm’s length price as per OECD guidelines, functional profile, assets, assumed risks of controlled and uncontrolled transaction are to be seen while screening. Besides, it is not possible to ignore specific Indian regulations on the subject. We have already noted the relevant rule (2) and (3) 10B of I.T. Rules, which specifically require to consider for comparison “the functions performed assets employed … and risks assumed by respective parties” In Rule 10(B)(1)(e) of I.T. Rules providing for determination through TNMM, it is clearly provided in Clause (iii) “the net profit margin referred to in Sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the difference if any”. These regulations have force of law and notwithstanding OECD guidelines, the T.P.O. can not refuse to consider specific characteristics of transaction, functions performed and assets employed as has been done in this case. Total disregard of regulations non-application of filters as above has resulted in faulty selection of comparison. All sizes of companies have been selected, only commonality being their dealings in softwares. We are unable to hold and approve the approach of T.P.O. as correct. The wide difference in the ratio of operating margins between 3.16% to 37.89% in final selection of comparable by the T.P.O., is a clear pointer to the fact that the selection made was faulty. It was imperative for the TPO to carry on further analysis and evaluation of companies selected and to see whether this variation is on account of FAR etc. The OECD guideline on this point is as under:
1.47 Where the application of one or more methods produces a range of figures, a substantial deviation among points in that range may indicate that the data used in establishing some of the points may not be as reliable as the data used to establish the other points in the range or that the deviation may result from features of the comparable data that require adjustments. In such cases, further analysis of those points may be necessary to evaluate their suitability for inclusion in any arm’s length range.
38. The TPO neither followed mandatory provision of Rule 10B quoted above nor guidelines of OECD and his computation of ALP is patently erroneous.
38.1 In the case of EIDU Pont de Nemours & Co. v. US (1979) 608 F2d 608, the US Court upheld the adjustment made on account of arm’s length determination although gross profit in the controlled transaction was comparable to the gross profit of uncontrolled transactions but the taxpayer was found to have claimed excessive expenses to reduce comparative net profit margin and, therefore, the adjustments were made and upheld. The case is an illustration how close minute examination of controlled and uncontrolled entities is essential under the Transfer Pricing Policy.
39. As regards the companies selected by the TPO, the Tax payer had further raised the following objections:
It has been pointed out that turnover of the taxpayer in the software development segment in the relevant period was Rs. 8.8 crores. Therefore, assessee while screening data, selected companies between turnover of INR 47 lakh to INR 25.71 lakh. Accordingly, it was submitted that the numericals showed that comparable companies selected by taxpayer formed proper mix of companies in terms of turnover and was an ideal set for comparison in terms of turnover and, therefore, the TPO’s objection was without any basis. It is not clear as to what according to the TPO was “low” turnover companies as he himself applied range of INR 50 lakh to INR 100 crore and, therefore, slightly less turnover than INR 50 lakh could not be construed as “low”. Therefore, according to the taxpayer there was lack of application of mind and arbitrariness in the approach of the TPO. It has been further pointed that turnover of the two companies “Integrated Hitech Ltd.” and “Luminaire Technologies Ltd.” in the relevant year was not less than INR 50 lakh. The taxpayer has given correct turnover figures in the paper book in Table 5 of the synopsis (the paper book). It has further been pointed out that Integrated Hitech Ltd. has been accepted by TPO in his own selection. It is accordingly argued that comparables selected by the taxpayer fully satisfied INR 50 lakh threshold limit set by the TPO except one company OCL Informatics Ltd. Yet the comparable selected by the taxpayer were held wrong and not accepted.
39.1 The TPO’s objection that taxpayer in the comparative selection of company did not consider the fact that some selected companies were in their initial years. This objection, according to the taxpayer is also without any material. It is submitted that the taxpayer company was incorporated on February 27, 1998 and the year under consideration is the fourth year of its operations. It has given list of incorporation of all other companies to point out that all the companies selected were incorporated before the taxpayer except for Zigma Software Ltd. and VGL Softech. It is further submitted that Sark System incorporated in 1998, and which was in operation for less than four years was selected by TPO himself as a comparable company. Therefore, there was no justification for discrediting the comparable selected by the taxpayer.
39.2 The other objection of the TPO that the taxpayer did not exclude companies having high ratio of trading activities and manufacturing activities was also without any basis or justification. The taxpayer while screening for comparable eliminated companies having manufacturing sales greater than 25% of total sales and trading sales greater than 25% to total sales. The TPO, on the other hand, applied a 10% threshold in this regard. The taxpayer has taken pains to show through Table 7 in the paper book that most of the companies satisfied the criteria of less than 10% sale with the exception of three companies i.e. Kushagra Software Ltd., Luminaire Technologies Ltd. and M Y M Technologies Ltd. It is therefore clear that the TPO failed to apply criteria and standards set by him and arbitrarily rejected the case of the taxpayer.
39.3 The TPO had also wrongly objected that taxpayer did not exclude companies having low employee cost. It has been stated by the taxpayer that insisting on low employee cost is not a very credible rational selection criterion and TPO, during the course of assessment proceedings did not point, with reference to any material, as to what is the economic rationale for using this criteria. It is relevant to mention that employee cost is low/similar throughout India and this is not a factor which would make material difference. Where such cost is extraordinary abnormal, the product dealt with is also extraordinary and, therefore, entire profile of the entity is required to be examined for comparison. Without prejudice to the above and on facts, the taxpayer as per Table 8 of the paper book page 2 has shown that companies selected by the assessee had several companies with cost below 10 or 10% and therefore fully satisfied the threshold limit set by the TPO himself except for five companies, yet the TPO, without any reasonable justification, did not accept the claim of the appellant.
39.4 It has been accordingly contended that TPO committed many errors and was wrong in discrediting list of comparables found and furnished by the taxpayer. The TPO could have carried fresh search only if the comparables drawn by the taxpayer was insufficient or had other deficiency. We are of the view that objection raised on behalf of the taxpayer are well-founded and were wrongly disregarded by the T.P.O.
40. In the end, the assessee appellant has analyzed that even after adopting the criteria/benchmarks set by the TPO for selection of comparables, there are seven companies which satisfy all the criteria and this way, average OP/TC were counted at 6.99%.
Table 9 – Appellant’s Comparables after applying all of the TPO’s Rejection Criteria
S.No.
Company
OP/TC (FY 2001-02 Data)
1.
C S Software Enterprise Ltd.
-25.12%
2.
Integrated Hitech Ltd.
3.16%
3.
Reynolds Software Solutions Ltd.(formerly
Known as Shine Computech Ltd.)
0.47%
4.
Sark Systems India Ltd.
27.91%
5.
V J I L Consulting Ltd.
5.24%
6.
Visu International Ltd.
-2.76%
7.
Zigma Software Ltd.
16.38%
Arithmetic Mean
3.61%
40.1 It is further seen that apart from specifically accepting comparable case of Integrated Hitech Ltd., the TPO did not make any adverse comment on 8 companies taken as comparable by the taxpayer. None of the objections raised by the TPO are shown to be applicable to those companies. It is therefore not clear why those companies were not taken as comparable companies. At page 22 of the paper book, the taxpayer has pointed out that arithmetic mean of OP/TC of those companies works out to 4.47% as per the following detail:
S.No.
Company
OP/TC
1.
MYM Technologies
4.81%
3
VJIL Consulting
5.24%
5
Zigma Software
16.38%
6
Sark Systems
30.00%
8
Shine Computech
0.47%
10
Visu Cybertech
-2.76%
11
CS Software
-25.12%
15
VGL Softech
6.74%
16
Top Media Entertainment
No data
available
Mean
4,47%
41. The taxpayer has also vehemently challenged general observation of the T.P.O. that selected company had a different product profile. The taxpayer has vehemently challenged above interpretation of different profile.
42. Smt. Himalini Kashyap, ld. CIT, DR supported the impugned order of the Transfer Pricing Officer and that of the ld.CIT(A). She argued that comparable as far as possible with reference to data available in public domain were selected by the T.P.O. to fix Arm’s length price. Therefore, on the reasons given by the T.P.O., the adjustment made in the assessment order of the taxpayer should be upheld. Alternatively, it was submitted that she does not have any material with her to challenge comparable operating margin of comparable companies relied upon by the assessee before the Appellate Tribunal or even those stated by the T.P.O. in his order. Therefore, to verify the claim, the matter should be remitted back to the T.P.O. and Arm’s length Price should be re-determined in the light of objections of the taxpayer. She also claimed that assessee relied upon fresh evidence.
43. All these submissions were opposed by ld. representatives of the taxpayer as factually incorrect.
44. On careful consideration of the rival submissions, we are of the view that contention advanced by ld. DR cannot be accepted. No fresh material has been relied upon by the taxpayer before the Appellate Tribunal. How and wherefrom revenue was to collect material in support of their case was the problem of the revenue and on that we do not wish to comment. We have also considered in detail order of the T.P.O., the very basis of addition/adjustment made in this case. For the reasons recorded above, we do not approve of the order and hold that Arm’s Length Price determined by T.P.O. is not sustainable.
45. As discussed in detail above, the Assessing Officer did not apply Indian regulation or guidelines issued by OECD on transfer pricing. The taxpayer, on the other hand, carried out proper screening of approximately 8000 companies carrying business of software in India and exporting services and goods abroad. It took into account characteristics of its company in question for the relevant assessment year and thereafter made selection of company after applying functional test with reference to assets employed and risk taken by those companies.
46. Though identical transaction could not be located even by the assessee, an attempt was made to find comparable transactions as close as possible to the controlled transaction. Besides the assessee has rightly relied upon the transaction in the case of Integrated Hitech Ltd. with operating profit ratio of 3.16%. This transaction has been accepted as comparable by the TPO and, therefore, there is nothing further for the taxpayer to establish that controlled transaction with AE was an arm’s length transaction. Besides the above, the T.P.O. also did not make any adverse comment on the following independent transactions given in the list of comparable by the taxpayer:
Company Name OP/TC
1. MYM Technologies 4.81%
2. VJIL Consulting 5.24%
3. Shine Computech 0.47%
4. VGL Softech 6.74%
46.1 We are not taking into account high profit or high loss making companies as comparables. All the above, independent comparables have shown profit margin of less than the assessee and, therefore, in the light of above evidence, there is no reason to hold that taxpayer’s international transaction with AE is at arm’s length. It has no tangible assets worked in no risk environment are very strong points of the taxpayer, not refuted on record.
46.2 While holding so, we have not adopted mean profit of several comparable found by respective parties because in spite of our repeated requests, the parties before us, were unable to show us any rule or decision under which average or mean margin (OP/TC) of different companies is to be taken. Tax administration and parties can work different Arm’s length price i.e. a range by the application of different methods. In such a situation, mean of Arm’s Length Price as provided in proviso to Section 92C(2) of the Act can be taken. But above Arm’s length range is not the same thing as average operating profits of different entities with different FAR worked through the same method as done in this case by adopting TNMM. The assessee has satisfied not one but several points of arms’ length range worked out on record. In our considered view, it is not necessary for the taxpayer to satisfy all points in the range. Even if one point is satisfied, the assessee can be taken to have established its case and in that situation, the onus is shifted to the department to show why taxpayer’s case be not accepted. Arm’s length price does not mean maximum price or maximum profit in the range. A willing buyer in an open market shall pay minimum and not maximum price for goods or services. Of course, quality and brand name are important but considered not so by T.P.O.as TNMM method was applied by him. Project profile and other factors were, therefore, not erroneously considered. As noted earlier, the case of Integrated Hitech has been specifically accepted as comparable by both the parties. On other four cases noted above, the T.P.O. or other revenue authorities have not made any adverse comment at any stage of proceeding. It was open to them in proceedings before the ld. CIT(A) or the Appellate Tribunal to show that PIL figure of Integrated Hitech or other four companies were wrong or on account of their FAR analysis, these entities could not be taken as “reliable” comparables for computation of the Arm’s Length Price. But no material was brought on record, no arguments advanced to reject the above transaction. Therefore, having regard to facts of the case and material on record, we accept them as comparable and accept the price disclosed by the taxpayer as Arm’s Length Price. Consequently, the addition of Rs. 1,45,73,857 is directed to be deleted. The view taken by us finds support from para 1.4 of OECD guideline which we quote below:
1.48 If the relevant conditions of the controlled transactions (e.g. price or margin) are within the arm’s length range, no adjustment should be made. If the relevant conditions of the controlled transaction (e.g. price or margin) fall outside the arm’s length range asserted by the tax administration, the taxpayer should have the opportunity to present arguments that the conditions of the transaction satisfy the arm’s length principle, and that the arm’s length range includes their results. If the taxpayer is unable to establish this fact, the tax administration must determine how to adjust the conditions of the controlled transaction taking into account the arm’s length range. It could be argued that any point in the range nevertheless satisfies the arm’s length principle.
47. Before close, we would like to draw attention to the following observation of the Supreme Court in the case of Parashuram Pottery Works Co. Ltd. v. ITO wherein it was observed as under:
It has been said that the taxes are the price that we pay for civilization. If so, it is essential that those who are entrusted with the task of calculating and realizing that price should familiarize themselves with the relevant provisions and become well-versed with the law on the subject. Any remissness on their part can only be at the cost of the national exchequer and must necessarily result in loss of revenue. At the same time, we have to bear in mind that the policy of law is that there must be a point of finality in all legal proceedings, that stale issues should not be reactivated beyond a particular stage and that lapse of time must induce repose in and set at rest judicial and quasi-judicial controversies as it must in other spheres of human activity.
48. That in the other ground, the taxpayer has raised objection on denial of deduction under Section 10A of the I.T.Act. The question of allowability of claim to the appellant under Section 10A has already been considered and decided in the assessment year 2001 in the case of this very assessee. The Bench, after following the decision of the Tribunal in the case of Legato Systems India (P) Ltd. v. ITO 93 TTJ 828, restored the matter to the file of the Assessing Officer to make further inquiry and allow deduction to the assessee.
48.1 The aforesaid decision is directed to be applied in the year under consideration as facts and circumstances as also objection of the revenue are similar as raised in that year. Besides, it may be pointed out that decision of the Tribunal in the case of Legato Systems (supra) has been approved by the Hon’ble Delhi High Court.
In the light of above discussion, the appeal of the assessee is allowed in terms indicated above.