NETRADYNE TECHNOLOGY INDIA PRIVATE LIMITED,BENGALURU vs. INCOME TAX OFFICER, WARD-5(1)(1), BENGALURU

For benchmarking software development services , In Transfer pricing Study Report [ TPSR], The assessee, selecting itself as a tested party,

In Purchase of software license for distribution segment, assessee taking itself as tested party, selected Transactional Net margin method as the most appropriate method adopting Profit level indicator of Operating profit margin of assessee at (-) 419.04% selected 4 companies whose margins ranging from (-) 0.38 % to 3.38 % having arithmetic mean of 2.01 %, stated that it is at arm’s length.

The ld. TPO examined the TPSR and rejected the same. He rejected the filters with respect to the availability of financials, manufacturing sales, trading sales and employee cost. The ld. TPO also found that assessee has not used the export turnover filter, persistent loss filter. Thereafter the ld. TPO proceeded to carry out search process selecting different filters. The ld. TPO also considered 21 comparables selected by the assessee, rejected most of them, except Great Software Labs Pvt. Ltd. and CG VAK Software Exports Ltd. In the new search process the TPO used Prowess Database using keywords of ‘computer software, software services and consultancy’. It reached at a set of 18 comparables and issued show cause notice. The assessee objected that in the TP search, Mindtree Ltd., Nihilent Ltd., Tata Elxsi Ltd., Infosys Ltd., Tata Consultancy Services Ltd. & Cybage Software Pvt. Ltd. are included whose turnover are huge compared to the assessee’s turnover and therefore they should be excluded. The TPO rejected the same stating that size of the company does not have any impact on the margin as it is a service industry. Assessee also objected to certain other inclusion. In the end, the ld. TPO selected 18 comparable companies whose margin at 35th percentile was 19.95% and 65th percentile at 32.14% resulted into median margin of 29.05%, computed ALP at Rs.42,80,87,359/- compared to the international transaction of Rs.39,35,57,009/- , added shortfall adjustment of Rs.3,45,30,350/-.

For software licence for distribution being royalty expenses amounting to Rs.19,00,747/- ld. TPO computed the margin of assessee at (-) 180.17%. Assessee selected 4 comparable companies in its distribution of software licence segment which was excluded by the TPO by rejecting some of the filters. The TPO carried out fresh search on Prowess Database selecting 9 comparables having 35th percentile of 9.66%, 65th percentile margin of 23.98% and median margin of 9.76%. Assessee objected the exclusion of certain companies which were rejected by the TPO and taxpayer objected regarding inclusion of certain companies. On the issue of comparability, huge turnover, brand value, lack of segmental information, etc., all these objections were rejected. Thereafter the ld. TPO reached at 9 comparable companies and determined the ALP at Rs.1,14,34,892 whereas the price paid by the assessee company was Rs.3,55,02,533 determining the shortfall of Rs.2,40,67,642. However the adjustment was restricted to quantum of purchases at Rs.19,00,747.

Based on this, the draft assessment order u/s. 144C was passed on 10.11.2023 determining total income of assessee at Rs.3,70,06,417. The assessee filed objections before the ld. DRP who passed directions on 28.8.2024 and after that the final assessment order was passed on 26.9.2024 at the total income of Rs.3,70,06,417.

The assessee aggrieved with the assessment order is in appeal before us. The assessee submitted revised Grounds of Appeal as under :-

The ld AR did not press ground no 1 to 5, 9 and 11 to 13. Therefore, those are dismissed.

Pressing Ground no 6 & 7 ld AR submitted that in the software development segment, the assessee has objected to inclusion of Mindtree Ltd. having turnover of Rs.9767 crores, L&T Infotech Ltd. that have turnover of Rs.11,562 crores, Wipro Ltd. that have turnover of 50,299 crores, Infosys Ltd. that have turnover of 85,912 crores, Tata Elxsi Ltd. that have turnover of 18,260 crores and Tata Consultancy Services Ltd. that has turnover of 1,35,963 crores. It was the submission that these companies have huge turnover, possess huge brand value and therefore they are not comparable with the assessee company. The ld. AR submitted that assessee is a captive service provider receiving remuneration of 15% on its cost. Therefore, such companies that have huge turnover are not comparable with the margin of the assessee.

Objecting to inclusion of Net4Nuts Ltd., he submitted that this company is functionally dissimilar as it is engaged in diversified businesses. He further stated that in this company margin abnormal fluctuations are noticed and does not have segmental data. The ld. DRP wrongly rejected this argument holding that this company is engaged in software development and a consulting company. The relevant extract of annual accounts was also shown; however, same was not excluded.

The assessee also as per ground No.8 submitted that certain companies were in assessee’s TPSR and comparability analysis which should have been included by the TPO, but the same were not included as the same were not part of search matrix of the TPO.

The ld. CIT (DR) submitted that regarding high turnover companies, the ld. TPO and the ld. DRP have given detailed reasons that in the services segment, higher turnover does not impact the margins of the companies. Their empirical data and studies given by the TPO & DRP showing yearwise turnover of various companies and their margins which clearly show that higher turnover does not impact the margin of the companies. Therefore, there is no reason that the companies with higher turnover should be excluded.

With respect to exclusion of Net4Nuts Ltd. & Consilient Technologies Pvt. Ltd., it was submitted that the DRP & TPO have given detailed reasoning for not including the above companies.

We have carefully considered the rival contentions and perused the orders of the ld. lower authorities.

We have carefully considered the rival contentions and perused the orders of the ld. lower authorities. Ground No.6 of the appeal is with respect to the arguments on the principal and ground No.7 is on the fact of each comparable. We have considered the argument of the assessee that turnover of the assessee of Software Development Services segment is merely Rs.39.35 crores. It is being compared with companies viz., Mindtree Ltd. which has turnover of 7697 crores, L&T Infotech Ltd. with turnover of Rs.11562 crores, Wipro Ltd. with turnover of Rs.50,299 crores, Infosys Ltd. having turnover of Rs.85,912 crores, Tata Elxsi Ltd. having turnover of Rs.1826 crores & Tata Consultancy Services with turnover of Rs.1,35,963 crores.

We find that due to the huge turnover of the comparable companies compared to the miniscule turnover of the assessee company in Software Development Services segment, those are not comparable at all.

It is undisputed that lower turnover filter of Rs 1 Crore is accepted by assessee as well as the learned transfer pricing officer to remove insignificant companies from comparability analysis. Therefore the issues is whether upper turnover filter should also be applied for comparability analysis or not. If higher and lower turnover filter is applied, it truncates large number of comparables, by eliminating comparables which have fairly large turnover compared to the tested entity. Naturally, large turnover companies have economies of scale compared to lower turnover entity.

Para number 3.43 in OECD Guidelines on Transfer Pricing (2022) says that in practice, both quantitative and qualitative criteria are used to include or reject potential comparables. Examples of qualitative criteria are found in product portfolios and business strategies. The most commonly observed quantitative criteria are Size criteria in terms of Sales, Assets or Number of Employees. The size of the transaction in absolute value or in proportion to the activities of the parties might affect the relative competitive positions of the buyer and seller and therefore comparability. Naturally higher turnover multiple times also shows that comparable company has higher market share compared to the tested entity. Naturally, higher market share gives freedom of selling larger volumes even at strained margins. The various studies carried out by NASSCOM and Dun Bradstreet also supports it. Though such studies have compartmentalised turnover filter of Rs. 1-200 hundred crores. Naturally in transfer pricing analysis lower turnover filter and upper turnover filter cannot be fixed and how to adopt the same depends upon the facts of each case looking at the turnover of the tested entity. In fact, the purpose of applying a filter is to have a manageable level of independent business concern having broadly similar level of turnover, intangibles, employees, and other assets. Guidance note issued by ICAI also advocates the same reasoning for adopting turnover filter.

In fact, the simplest way of explaining what an arm's-length price is how independent parties price a particular transaction therefore that is how related parties should also price it. To arrive at such an arm's- length price, economies of scale should also be similar/ comparable. Therefore, the upper turnover filter is necessarily required to be employed for better determination of arm's-length price. Honourable Bombay High Court in case of Pentair Water India (P.) Ltd. vs. Additional Commissioner of Income-tax, Goa [2014] 47 taxmann.com 132 (Panaji)/[2014] 164 TTJ 502 (Panaji)[23-05-2014] has also accepted the fact that if the turnover of the comparable is multiple times compared to the turnover of the tested entity, such comparable company should be excluded from comparability analysis.

We also direct to exclude the above comparable selected by the ld TPO for one more reason. All these companies are a part of renowned conglomerate and has huge brand value in the market of ITes / software development. These brands do have an added advantage in gaining new clients, extracting / mining new work from existing clients and larger pitch before public and Private sector. This is due to the intangible [whether recorded in books or not] of these brands. Thus, this makes a lot of different in asset size of the comparable with a captive service provider working on cost plus basis of remuneration.

Therefore, respectfully following the decision of the coordinate bench in assessee's own case in earlier year, we direct the learned transfer pricing officer to remove all these above companies from comparability analysis. In view of this, we direct the ld. AO to exclude the above comparables.

With respect to the objection of the assessee of inclusion of Net4Nuts Ltd., the assessee challenged the same before the ld. lower authorities that it is functionally dissimilar as it is engaged in the diversified business, it has abnormal fluctuation in the profit and therefore it should be excluded. The ld. lower authorities did not consider the objection of the assessee. We have carefully perused Para 14 of the DRP direction wherein it is stated that this company is engaged

The next comparable company objected to by the assessee is Consilient Technologies Ltd. Assessee has objected to the same stating that it is functionally dissimilar as it is engaged in diversified business, has abnormal fluctuation in the profit and segmental information is not available. The lower authorities have rejected the contention of the assessee. The ld. DRP has held that this company is rendering IT design & development services and as per corporate information available, it is engaged in the activity of software development. Before us, the ld. AR repeated the same argument. We find that the ld. DRP has given a reason that this company is engaged in the Software Development Services and is not earning revenue from sale of products which is certified by its Auditor and therefore this company is functionally comparable. Furthermore, the argument of abnormal profit was also rejected for the reason that it cannot be a reason for exclusion of any company, unless extra-ordinary event impacting the margin is shown. As this comparable company is in the single segment of Software Development Services, the argument of the assessee that it did not have segmental information is also not relevant. Therefore, according to us, there is no infirmity in the order of the ld. lower authorities for not excluding this comparable company. Accordingly ground Nos. 6 & 7 of the appeal are partly allowed.

Vide ground No.8, assessee has stated that there are 6 comparable companies which are functionally and qualitatively similar to the appellant, hence should have been included in the final list of comparables. The companies challenged by the assessee is exclusion with respect to certain companies which are in the accept/reject matrix of the assessee and same have been in Search matrix of the ld. TPO and upheld by the DRP. The reason given by the DRP is that those companies did not appear in the search matrix of the TPO and therefore it cannot be now included.

We have considered the argument of the ld. AR and LD DR . The issue before us that when the ld TPO has computed the arm's length price of an international transactions in manner by (i) Selecting tested party , (ii) Identifying the database, (iii) search on database by applying qualitative filters of search key words relevant to the functions of the assessee (iv) Defining quantitative filters and applying them (V) Selecting set of comparables, (vi) applying various adjustments such as working capital and risk adjustments etc, (vii) thereafter determining the Arm's length price of the Transactions. Now bypassing all these steps, assessee says that some comparable companies should also be included as those are providing similar functions as of the assessee. As the TPSR of the assessee stands rejected and not opposed, now the search process and filters applied by the assessee are no more relevant. Those companies which are argued to be included are also part of the same rejected TPSR. Thus, the arguments are though TPSR is rejected but resultant companies should

Another reason for rejection of this argument is that it is not shown to us by assessee that this companies does appear in the accept reject matrix of the ld. TPO, but those have been wrongly excluded by ld TPO. Against this, the Ld TPO and LD DRP has categorically held that those companies did not find place in search matrix of the assessee. This reason of the ld DRP and Ld TPO remains unassailed.

One more reason for rejecting the arguments of the ld AR is that, if one company stated to be included which favours the assessee, then there may be several other companies which are also having similar far and not in the comparable set of the ld TPO, those should also be included. Therefore, if such an argument is accepted, it will make the whole search process of the LD TPO or of the assessee useless and the determination of the ALP would be vitiated.

If such argument is accepted, it would be a perfect case of cherry picking and search process will lose its sanctity. We find that the TP Study Report of the assessee is rejected by the TPO and therefore each and every step, filter, etc. of the TP Study Report prepared by assessee are not now relevant. There is no objection to the whole search process employed by the ld TPO except application upper turnover filter. Thus, if in the systematic process adopted by the TPO, few comparables are included without entering the accept/reject matrix of the TPO. then it will definitely amount to cherry picking. Therefore, as these companies did not appear in the search matrix of the TPO, such random companies cannot be added to the data set of comparability analysis. Therefore ground No.8 of the appeal is dismissed as we do not find any infirmity in the order of the ld. TPO and direction of the ld. DRP.

Ground No.10 is with respect to non-granting of working capital adjustment to the assessee. The ld. TPO has dealt with this issue at para 13 wherein it was stated that assessee has not been able to demonstrate that working capital difference had impacted its profit. Assessee did not produce any analysis of whether the comparable companies have financed their working capital by own funds or borrowed funds, whether any cost has been incurred on the working capital by the comparable companies and if so how the cost of such working capital had an impact on the margins of the comparable. We find that the TPO has selected his own comparables on fresh search and therefore it is for the TPO to show that working capital of comparable companies and working capital of the assessee company which is a captive service provider are same and it does not have any impact on the margin of those comparable companies. As the comparables are selected by the TPO, the ld. TPO is bound to show that the comparable companies profit margin are not inflated due to the working capital employed by them. It is unfair on the part of the TPO to put that onus on the assessee, when he has computed the ALP. The finding must be in TPO order that no adjustment u/r 10B (1) (e) (iii) is required by showing the data and its computation mechanism. This has not been done by the ld. TPO. Therefore we restore the this issue back to the file of the ld. TPO to grant working capital adjustment to the assessee company in accordance with law, if available, after granting opportunity of hearing. Accordingly ground No.10 of the appeal is allowed.

In the result, the appeal filed by the assessee is partly allowed.