M/S SAP LABS INDIA PRIVATE LIMITED ,BANGALORE vs. JOINT COMMISSIONER OF INCOME TAX SPECIAL RANGE-6 , BANGALORE

The assessee has filed this appeal challenging the final assessment order dated 17.10.2018 passed by the A.O. u/s 143(3) r.w.s. 144C(13) of the Income-tax Act,1961 ['the Act' for short] for assessment year 2014-15 in pursuance of directions given by Ld. Dispute Resolution Panel (DRP).

At the time of hearing, the Ld. A.R. restricted his arguments on the following issues and did not press other grounds:- a) Transfer pricing adjustment

In respect of transfer pricing adjustment also, the Ld. A.R. sought exclusion of 5 comparable companies and inclusion of 2 comparable companies. Besides the above, the Ld. A.R. sought that the working capital adjustment and risk adjustment be given.

The assessee is engaged in the business of providing software development and related service to SAP group. It is a subsidiary of SAP-SE, Germany and SAP Deutschland K.G. & Co. A.G., Germany. During the year under consideration, it has received Rs.1465.64 crores from Software development and related services provided to it’s A.E. The assessee adopted TNM method to benchmark its transactions. The assessee adopted operating profit by total cost as profit level indicator (PLI). The assessee declared PLI of 10.16%. The TPO rejected the transfer pricing study of the assessee and selected following companies:-

The average margin of the above said comparables work out to 29.40%. Accordingly, the TPO proposed transfer pricing adjustment of Rs.259.40 crores. After the direction issued by DRP, the TP adjustment came to be reduced to Rs.241.18 crores.

In respect of transfer pricing adjustment, The Ld. A.R. submitted that (i) the assessee seeks exclusion of following 5 comparable companies:- a) Infosys Ltd. b) Larsen & Toubro Infotech Ltd. c) Persistent Systems Ltd. d) Thirdware Solutions Ltd. e) Cigniti Technologies Ltd.

With regard to inclusion and exclusion of companies and working capital adjustment, the Ld. A.R. placed his reliance on the decision rendered by Huawei Technologies Ltd. Vs. ACIT (ITA No.339/Bang/2019 dated 22.7.21). He submitted that all the 5 companies sought for exclusion and 2 companies sought for inclusion have been accepted under similar circumstances in the above said case.

As regards wrong computation of margin, the ld. DR submitted that the issue of treating provision for bad and doubtful debt as non-operating expense has been discussed in the order of CIT(Appeals) and the action of the AO is to be upheld. So there is no error in computation of margin of this company.

On the next argument of the assessee that there was Business restructuring and Extraordinary event, the merger of Infosys Consulting India Limited (ICIL) had been accounted for under pooling of interest method, and that the assets and liabilities of ICIL had been transferred to Infosys Limited on a going concern basis, therefore, Infosys Ltd should be excluded from the list of comparables; the ld. DR submitted that a merger can be considered as extra ordinary event if it had a significant impact on the profits or margins of such other company. The assessee had not indicated that such a merger had impacted the revenue of Infosys Ltd. There is nothing to show that assessee is adversely impacted if this company is selected as a comparable. Therefore, this company cannot be excluded on the reason of merger.

Another argument of the ld. AR is that Infosys Ltd. is engaged in diversified operations such as business consulting, engineering and outsourcing services and it offers software product and platforms. The annual report clearly specify income deriving from sale of products. Significant R&D, brand value, size and scale of IT(TP)A No.3271/Bang/2018 M/s. Sap Labs India Pvt. Ltd., Bangalore Page 5 of 18 operations of Infosys Ltd. made it functionally dissimilar to the assessee. There was no significant information on products and services segment as segmental data was not available.

The ld. AR next contended that Infosys Ltd. had huge brand value and contributed to its growth in revenue and hence not comparable. The ld. DR submitted that brand is not restricted to parent company but also available to all associated companies if they are using brand name. In the case of assessee also, it was using the brand ‘Huawei’ in its products and assessee is expected to provide service commensurate with the brand image. Thus Infosys Ltd. cannot be excluded because of brand value and the assessee is also at the same footing.

The ld. DR submitted that as regards the reliance of the appellant on the order of TPO for AY 2013-14, each year needs to be looked into separately and the comparables need to be selected after examining the issue of filters applied and the functionality of the company based on the financials or the other data available with the TPO. So this argument was rejected.

The ld DR submitted that the platforms/products and solutions of the company are not off the shelf products as argued by the assessee. The company had revenue from software services of RS.42,531 crores and that from software products was only Rs.1,810 cores. As such, the product revenue constituted a meagre 4.08% of total operating revenue. It passed the filter of ‘Revenue from Core services greater than 75% and functionally comparable to assessee. The meagre revenue from software products does not impact the margins of company from software development and segmental data is not required to be considered.

On the contention of the assessee that Infosys Ltd. has a huge R&D expenditure, the ld. DR submitted that company has incurred R&D expenditure of Rs.873 crore which is a meagre 1.96% of its total operating revenue. From the Note 1.1 of the Annual Report at page 50, the development of intangibles and its impact on the revenue and profitability can be inferred as meagre. The assessee has failed to establish that differences, if any, on account of R&D, brand and intangibles have material effect on the margin of the said company. Further the assessee itself considered such companies as comparable which had R&D expenditure to sales ratio less than 3%. The reason given by assessee to apply such a filter was to select companies which do not own intangibles and are pure service providers. Thus this company cannot be rejected as a comparable because of R&D or intangibles.

We have heard both the parties and perused the material on record. The issue of comparability of Infosys Ltd. came up for consideration before the Tribunal in the case of Microsoft Research Lab India Pvt. Ltd. [IT(TP)A No.3131/Bang/2018 for the AY 2014-15. Vide order dated 05.02.2020 the Tribunal excluded this company from the comparables holding as follows:- “(i) Infosys Limited : The turnover being rs.44,341 Crores and it is functionally not comparable as the turnover is more than 500 times of the assessee turnover of Rs.84.09 Crores. The company is engaged in developing software products Pinnacle and was rejected by the DRP in assessee own case for the Assessment Year 2011-12. Further has high

Since the facts of the case are similar relating to SWD segment to the case of Microsoft Research Lab India Pvt. Ltd. (supra), we direct exclusion of Infosys Ltd. from the comparables.

The ld. AR submitted that Larsen and Toubro Infotech Limited (L&T) should be excluded from the list of the comparables as it is functionally different from the appellant on account of following: • Significant amount of Intangible assets including IPR and business rights • Significant Brand value • Extraordinary events during the year • Significant Overseas Staff costs and sub-contracting expenses.

Further on the assessee’s submission that this company has subcontracting expenses, the ld. DR submitted that it is very common practice in the software development sector that personnel for the coding e.g. programmers are taken on contract by the companies for the duration of the project and they are just like employees of the developer as they function under control and direction of the developer. So sub-contracting expenses do not make L&T functionally different from the appellant. This is entirely different from the case where the software development work itself is outsourced to the software developer e.g. the AE of the appellant has outsourced its work to the appellant. So these arguments of the appellant are to be rejected.

The ld. DR submitted that the issue of brand of this company is similar to the contentions of the revenue in Infosys Ltd. As regards the argument that it was a product company, the ld. DR submitted that from the annuals of the company it is evident that the company is in software development. On perusal of the 'Director's Report' (as in the Annual Report), under the sub head 'Performance of the Company', it is observed that the company is operating in the sector of 'IT services'. The IT service sector revenue is categorized into three parts on the basis of the nature of business of the clients. Of the total IT services revenue, 43.5% comes from the clients from services sector, 48.6% from clients operating in manufacturing sector and 7.9% (for nine months) from clients operating in the Telecom sector. The basic work of L&T remains the same i.e. providing software development services to its clients operating in different business segments. Earnings in foreign currency (Notes forming part of accounts annual report) also shows the major earnings are from software export. The revenue recognition method in the 'Notes forming part of Accounts' also refers to services performed on 'fixed price basis' or 'time and material basis'. Thus the functional profile of the company is same as that of the assessee company. The ALP in the case of the assessee has been determined by treating TNMM as the most appropriate method. This method requires broad comparability of the functionality of the comparables. So in case the company is in Software Development, it would not matter as to what kind of customer it serves as the broad range of services remain the same and that is the development of software. Further, it will not matter whether the comparable develops complete software for its client e.g. develops a final product as per demand of the client or develops only some software modules, as per the requirements of its client. The function remains same. A company can be considered in the business of Software Products only if it

As regards the contention of assessee that the product engineering business segment of L&T was transferred to L&T Technology services Ltd and the same had an impact on the margins of this company, the ld. DR submitted that a perusal of the annual report of L&T shows that the company had three business segments — services cluster, industrials cluster and telecom cluster (product engineering services). W.e.f. Jan 1, 2014, the Product Engineering Services (PES) was transferred to L&T Technology services Limited, and accordingly only the nine month revenue results from Product Engineering Services (PES) were considered in the company's financial statement for the year. As such there wasn't any impact on functional comparability. The appellant has not pointed out any impact on revenue which could have increased the margins of this company or impact on the functional comparability on account of such business transfer. In fact, on account of such transfer, the quantum of revenue will be less which will only lower the margins.

On the assessee’s argument that L&T has substantial Overseas staff cost and sub-contracting expenses, the ld. DR submitted as in the case of Infosys, no such ground of appeal

The ld. DR submitted that the reference of assessee to website of the company is misplaced, as the same relates to entire group of Persistent Systems. Further, the annual report of the company is more reliable than the website as the latter is dynamic in nature and may represent the status at the time of accessing the same

As regards expenditure incurred towards R&D, the ld. DR submitted that as per page 195 of the annual report the same was Rs.39.61 million, which constitute meager 0.33% of operating revenue. As discussed supra while dealing with Infosys ltd as a proper comparable, in its TP study the appellant has itself acknowledged that R&D expenditure which is less than 3% of the sales is an appropriate filter to reject companies which are in R&D or in development of intangibles. So as per appellant's own yard stick this company cannot be rejected on account of R&D or intangibles. Further the value of intangible assets of Persistent systems was only Rs.162.85 million constituting 1.36% of operating revenue. There is no reference to any intangible assets or patent owned or developed by the company, in the stand alone annual report. There is also no acquisition of intangibles during the year. Thus, it can be inferred that the R&D and intangible assets do not have impact on the revenue and profitability of the company. On perusing the 'summary of significant accounting policies' in the annual report (page 164 of annual report) of Persistent Systems, it is observed that intangible assets are primarily the software licenses purchased and contractual rights acquired' and are valued on the basis of 'purchase price and attributable cost of bringing the asset to its working condition for intended use'. Nowhere there is reference to the IPR generated by the company itself and its valuation. Thus the intangibles in the fixed assets schedule are on account of software/contractual rights purchased and used for the development purposes. Further, even if there is any self-generated intangible, not being on account of normal purchase as in case of software, as discussed supra, in the case of appellant too, while it is performing its functions of Software Development, substantial intangibles are generated. The appellant has failed to establish that differences, if any, on account of R&D, brand and IRPs have material effect on the margin of the above company, in terms of clause (i) of sub-rule (3) of Rule 10B, which provides that an uncontrolled transaction shall be comparable to an international transaction if none of the differences, if any, between enterprises entering into business transactions or likely to materially affect the profit arising from such transactions in the open market.

The contention of assessee is that there was occurrence of extraordinary events during the year under consideration in the case of this company and so it should not be considered as a comparable. The ld. DR submitted that page 27 of annual report relates to the consolidated financials of the group and the extra ordinary event relates to acquisition by Persistent Systems Inc (PSI) and not by the Indian entity namely Persistent Systems Limited which has been considered as a comparable by the TPO. The appellant has not explained as to how these acts of subsidiaries have impacted the profit margins of Mis Persistent Systems. So this argument of the appellant is to be rejected.

The ld. DR further submitted that this company was upheld to be functionally comparable to a software service provider company by the Hon'ble ITAT Bangalore in the case of M/s. Advice America Software Development Centre Private Limited (in ITA (TP) No. 2531/Bang/2017 dated 23.05.2018 (A.Y. 2013-14). In Agnity India Technologies Pvt. Ltd. (supra) also the ITAT had held Persistent Systems Ltd to be a proper comparable for software development activities.

Considering above, the ld. DR submitted that the ground relating to this comparable has to be dismissed.

This comparable i.e., Persistent Systems Ltd. came up for consideration before the Tribunal in the case of Microsoft Research Lab India Pvt. Ltd. (supra) wherein this company was excluded from comparables observing as under:- “We have perused submissions advanced by both sides in the light of the records placed before us. At page-1432, it is observed that companies operations predominantly relates to providing software products services and technology, innovation covering full life cycle of product to its customers. It is observed that Delhi ITAT in case of Aginity India Technologies India private limited (supra) has held as follows: “Persistent systems Ltd was excluded from the list of comparable companies on the ground that this company was a software product company and segmental information on SWD services was not available. The Tribunal in coming to the above conclusion referred to the decisions rendered by ITAT Delhi Benches in case of cash edge India private limited vs ITU in vide order dated 23/09/15 and the details of orderable Delhi High Court in case of sexual India private limited (supra). The findings in this regard are contained in paragraph 4.14 to 4.16 of its order.” Respectfully following the same we are of considered opinion that this company deserves to be excluded from the final list.” We, respectfully follow the coordinate Bench decision, and direct the TPO to exclude the comparable from the final list of comparable for determination of ALP.”

Following the aforesaid decision, we direct to exclude Persistent Systems Ltd. from the list of comparables.

The ld. AR on the basis of detailed submissions stated that this company is engaged in sale of products and has to be excluded.

The ld. DR, on the other hand, submitted that a perusal of the financials of this company shows that the revenue of this company is only from sale of software development services and not from sale of any products. As per page 16 of the financials, the company is engaged in the business of software development and consultancy service and that the operation of the company comprises of software, development, implementation and support services. Though at page 2 of the P&L A/c statement the company has mentioned revenue from sale of products at Rs.20675/- lakhs, however it is clearly mentioned that the revenue was on account of export of software services to the tune of Rs.20,194.37/- lakhs, from software services from local unit Rs.414.07/-lakhs, from subscription and training Rs.59.32/- lakhs, from sale of licenses 7.98 lakhs. The revenue from software licence constitutes a meager 0.03% of total operating revenue. Thus it is very clear that this company is predominantly into sale of software services and hence can be safely taken as a comparable. Further at page 7 of annual report it is mentioned that the company has acquired intangible asset relating to software purchased for company's internal use which was capitalized as the cost of acquisition. Thus this company is a proper comparable.

On the contention of assessee that the TPO has erroneously considered forex loss as non-operating expense, the ld. DR submitted that the TPO has considered forex gain/loss as operating in nature. The CIT(Appeals) directed the TPO to reverify this aspect in relation to this comparable also and if the forex loss is not considered as operating in nature then he should treat it as operating and recompute the margin of this company.

We have heard both the sides and perused the material on record. Similar issue came up for consideration before the Tribunal in the case of Microsoft Research Lab India Pvt. Ltd. (supra) wherein the Tribunal held as under:- “We have perused submissions advanced by both sides in the light of the records placed before us. On perusal of the annual reports placed at page 573 of paper book volume 2, it is observed that this company has developed its own product by the name “PAPA”. It is observed that this company has incurred huge expenses towards import of software services evidencing outsourcing of software services unlike that of assessee. It is also observed that this company is into production of software product and therefore cannot be functionally is held similar to a contract service provider under this segment like that of assessee. Ld.Counsel placed reliance upon decision of coordinate bench of this Tribunal in case of Nomura Research Institute Financial Tech (India) Pvt. Ltd., vs DCIT in vide order dated 26/10/2018.

The ld. DR submitted that the TPO noted that this company is into development of computer software & services and therefore functionally similar to the assessee. The contention of the assessee was that this company had acquired to companies i.e. Gallop Solutions Inc and Gallop Solutions P. Ltd. which are extra ordinary events. The TPO observed that these two companies were shown as 100% owned subsidiary of this company and were not merged. In other words, these two companies still remained as separate legal entities and do not impact the standalone profit margin of the company. Whereas the assessee had erroneously compared and considered the consolidated figures of this company.

This issue was considered by the Tribunal in the case of Microsoft Research Lab India Pvt. Ltd. (supra) wherein this company was excluded from comparables observing as under:- “ We found this comparable was excluded by the co-ordinate Bench of the Tribunal in the case of Marwell India Pvt. Ltd. Vs. DCIT (supra) at page 18 para 4.2 (a) of the order as under : “We have perused submissions advanced by both sides in the light of the records placed before us. We have also perused the annual report very carefully and is observed that this company is involved exclusively into software testing and has created innovations in the software testing. It is also observed that this company is acquired hundred percent shares in a U.S.-based software testing service company called Gallop Solutions Inc based in Texas USA. It is also observed that this company has been listed on Bombay stock exchange, Bangalore stock exchange and maybe Madras stock exchange with a paid-up capital of Rs. 22.92 crores. It is an undisputed fact that entire revenue has been generated by this company from software testing services rendered to its independent clients as against simple testing carried out by assessee of integrated circuits along with designing, customer support of integrated circuits related ancillary services provided by assessee only to its AE. Considering the holistic approach having regards to the annual reports of this company and the specialised services provided by this company to its own clients in the field of software testing as against captive service provided by assessee exclusively to its IT(TP)A No.3271/Bang/2018 M/s. Sap Labs India Pvt. Ltd., Bangalore Page 15 of 18 AE, we are of considered opinion that this company cannot be held as a good comparable with that of assessee. Therefore we direct Ld. AO/TPO to exclude this company from the final list of comparables.” Following the judicial precedence, we found the company is in specialized area and has to be excluded. Accordingly, we direct the TPO/A.O. to exclude from the final list of comparables”.

In view of the above decision of the Tribunal, we find no infirmity in the order of the CIT(Appeals) in exclusion of this company from the comparables.

Following the above said order, we direct exclusion of above said 5 comparable companies.

The assessee has sought inclusion of I2T2 India Ltd. and Evoke Technologies Ltd. The coordinate bench in the case of Huawei Technologies India Ltd. (supra) has directed inclusion of above said two companies with the following observations:-

The ld. AR submitted that this company was rendering software development services and consulting activities and hence comparable to it, however the same had wrongly been not accepted by the TPO by holding that RPT information was not available. It was submitted that the company satisfied all the filters adopted by the TPO and hence should not be rejected as comparable only because RPT information is not available in the financials of this company.

The ld. DR submitted that perusal of the annual report of this company (Directors report- Acknowledgements) shows that the company is in the ITES industry and has done transaction processing work, which is not functionally comparable. Further RPT information is an important aspect in selection of comparables and in absence of such data a company cannot be considered as a proper comparable.

This issue was considered by the Tribunal in the case of LSI India Research & Development Pvt. Ltd. in IT(TP)A No.3170/Bang/2018 dated 7.10.2020 wherein it was held as follows:- “27. As far as inclusion of I2T2 India Ltd. is concerned, we find that in the case of LG Soft India (P.) Ltd. (supra) this company was directed to be included. The Tribunal in para 11 of its order held that the TPO excluded this company for the reason that the Related Party Transaction (RPT) had not been disclosed in the annual report. The Tribunal held

Following the aforesaid decision, we direct for inclusion of this company i.e., i2T2 India Ltd. (ii) Evoke Technologies Ltd.

The ld. AR submitted that this company was not accepted by the TPO on the ground that standalone financials of this company included unaudited revenue and expenditure of a branch located outside India. The company is mainly in software development and hence the same is functionally similar to it and unaudited financial of the branch office cannot be a reason to reject this company as a comparable.

The ld. DR submitted that a perusal of the statutory auditor's report shows that the financial statements include branch revenue of Rs. 9,24,86,670/- and profit of Rs. 1,41,11,040/- based on unaudited financial statement of the Branch outside India. So the data of this company cannot be considered as reliable. As such this company cannot be considered as a proper comparable. Further, as per the geographic segmentation information, the revenue from India was given to be Rs. 3621.72 lakhs and that the revenue from US was given to be Rs. 924.87 lakhs. Thus it can be seen that the export revenue constitute only 20.34% of the total revenue. Therefore this company cannot be considered as comparable.

This company was considered by the Tribunal in the case of Citrix R&D India Pvt. Ltd. in IT(TP)A No.3134/Bang/2018 dated 29.01.2020 wherein it was held as follows:- “15. The assessee seeks inclusion of Evoke Technologies Pvt. Ltd. which was rejected by the TPO as a comparable company for the reason that data relating to this company was not available in the public domain and that it had a different financial year ending. Before the DRP also, the assessee did not challenge the action of the TPO in excluding the aforesaid company because the assessee did not have a data relating to this company. The assessee is now seeking inclusion of this company on the basis of decision rendered by the Hyderabad Bench of ITAT in the case of Infor (India) Pvt. Ltd. for AY 2014-15. In the aforesaid decision, the Hyderabad Bench took the following view :- “3. As regards Evoke Technologies is concerned, the contentions of the assessee are that this company is functionally similar to the assessee, whereas the TPO & DRP have held that the financials of this company include the revenue of one branch outside India which are unaudited and hence are not reliable. The learned Counsel for the assessee however, drew our attention to page 963 of the Paper Book, which is part of the Annual Report of Evoke Technologies Ltd wherein the revenue of IT(TP)A No.3271/Bang/2018 M/s. Sap Labs India Pvt. Ltd., Bangalore Page 17 of 18 Indian Branch of assessee is separately shown. Taking the same into consideration, we direct the AO/TPO to reconsider the comparability of this company by taking the revenue from Indian Branch only. Thus, the ground for Maveric Systems Ltd is rejected and for Evoke Technologies Ltd is allowed for statistical purposes.”

Following the aforesaid decision, we remit the issue to the AO/TPO for fresh consideration and decision on similar lines.

Following the above said decision rendered by the co-ordinate bench, we direct inclusion if i2T2 India Ltd. The comparable company Evoke Technologies Ltd is restored to the file of AO/TPO for examining the same afresh.

The next claim of the assessee relates to the granting of working capital adjustment. The Ld A.R submitted that the working capital adjustment was given in the assessee’s own case in AY 2012-13 in IT(TP)A No.1939/Bang/2017 dated 31.10.2018. Accordingly, consistent with the view taken in the assessee’s own case, we direct the AO/TPO to grant working capital adjustment.

The next claim of the assessee relates to granting of risk adjustment. The Ld A.R submitted that the assessee was granted risk adjustment in AY 2011-12 in ITA No.566/Bang/2016. Following the same, we direct the AO/TPO to grant risk adjustment to the assessee.

The last issue relates to the claim of deduction of education cess, secondary and higher education cess paid by the assessee during the year under consideration. The assessee has raised this claim by way of additional ground. The Ld A.R submitted that the IT(TP)A No.3271/Bang/2018 M/s. Sap Labs India Pvt. Ltd., Bangalore Page 18 of 18 above said claim of the assessee was accepted by the Tribunal in the assessee’s own case for AY 2012-13 in dated 23.07.2021. We notice that the Tribunal has followed the decision rendered by Hon’ble Rajasthan High Court in the case of Chambal Fertilisers and Chemicals Ltd (ITA No.52/2018 dated 31.7.2017). The Ld A.R also submitted that the Hon’ble Bombay High Court has expressed the view in the case of Sesa Goa Ltd that the education cess, secondary and higher education cess is allowable as deduction.

Accordingly, following the above said decision, we restore this issue to the file of AO to examine the claim of the assessee in accordance with the decision rendered in the cases cited supra.

In the result, the appeal of the assessee is treated as allowed. Order pronounced in the open court on 23rd Dec, 2021