RED HAT INDIA P.LTD,MUMBAI vs. DCIT CIRCLE 15(3)(1), MUMBAI

O R D E R Per Shamim Yahya (AM) :- This appeal by the assessee is directed against the order of the Assessing Officer passed under section 143(3) r.w.s.144C(1) of Income Tax Act, 1961 (hereinafter "the Act") dated 27.12.2017 for assessment year 2014-15 passed pursuant to the direction of the Dispute Resolution Panel (DRP)-2, Mumbai, dated 27.09.2018.

disregarding the law relating to determination of the arm's length price under Rule 10B of the Income-tax Rules, 1962 ('the Rules') 1.2 The Ld. TPO and Hon'ble DRP erred on facts and in law, in not appreciating the business model followed by the Appellant. In doing so, have grossly erred in: a) disregarding the 'License and Service' Agreement justifying the arm’s length nature of transaction of payment of "Royalty" and 'Service fees'; b) misinterpreting the payment of 'service fees' as a payment of 'royalty' based on its own conjecture and surmises, and ignoring the explanations offered by the Appellant; c) disregarding the fact that the payment of 'service fee' was in connection with the support provided by AE directly to the end customers of the Appellant; d) disregarding the fact that the Appellant acts as a limited risk distributor and earns assured margins on revenue in 'Subscription segment'; and e) disregarding the fact that due withholding taxes were deducted on the service payment made to the AE

1.3 The Ld. TPO and Hon'ble DRP confirming the Ld. TPO's action erred on facts and in law in disregarding the Transactional Net Margin Method (TNMM) as the most appropriate method for determining the arm's length price of payment of service fees and applying the 'Other Method' in contravention of Rule 10B of the Rules

Adjustment relating to international transactions pertaining to provision of software support services

1.4 On facts and in law, the Ld. AO erred in confirming the Ld. TPO's action of rejecting Akshay Software Technologies Limited as comparable company despite this comparable being reinstated by the Hon'ble DRP and thereby, violating the provisions of Section 144C(10)of the Act.

1.5 The Ld. TPO and Hon'ble DRP confirming the Ld. TPO's action erred on facts and in law in determining the arm's length price for provision of software support services and thereby making an adjustment of INR 12,558,704 to the taxable income of the Appellant. In doing so, have grossly erred in a) modifying the economic analysis carried out by the Appellant in the Transfer Pricing documentation without providing any cogent reasons; b) rejecting various comparable companies selected by the Appellant in the Transfer Pricing Documentation and considering various comparable companies as comparable to the Appellant without appreciating that such comparable companies are functionally dissimilar to the Appellant; and c) disallowing relevant adjustments as per the provisions of Rule 10B(1) and Rule 10B(3)

Adjustment relating to international transactions pertaining to provision of sales & marketing support services 1.6 The Ld. TPO and Hon'ble DRP confirming the Ld. TPO's action erred on facts and in law in determining the arm's length price for provision of sales and marketing support services and thereby making an adjustment of 1NR 2,034,038 to the taxable income of the Appellant. In doing so, have grossly erred in a) modifying the economic analysis carried out by the Appellant in the Transfer Pricing documentation without providing any cogent reasons;

Red Hat India Private Limited 3 b) rejecting various comparable companies selected by the Appellant in the Transfer Pricing Documentation and considering various comparable companies as comparable to the Appellant without appreciating that such comparable companies are functionally dissimilar to the Appellant; and c) disallowing relevant adjustments as per the provisions of Rule 10B(1) and Rule 10B(3) Corporate tax Additions on account of unearned revenue from subscription services of Rs. 18,54,92,479

2.1 The Ld. AO and Hon'ble DRP erred on facts and in law in making an addition of Rs. 18,54,92,479 pertaining to subscription services and forming part of the 'unearned revenue', disclosed in the liabilities side of balance sheet of the Appellant, as income of the current year, without appreciating the fact that the impugned amount is in the nature of advance and is not chargeable to tax in the current year;

2.2 The Ld. AO and Hon'ble DRP, while itself accepting the fact that the Assessee is following percentage completion method of revenue recognition for services as per Accounting Standard - 9, issued by ICAI (AS-9), has erred on facts and in law making the addition on the erroneous premise that the completed contract method of revenue recognition is not applicable to the facts of the Assessee;

2.3 The Ld. AO and Hon'ble DRP erred in understanding the nature of services and the contractual framework between the Appellant and its customers and while doing so: a) erred on facts in holding that the services are complete on entering of the subscription services agreement with the customer, without appreciating that the agreement is for rendering of services for a period which generally exceeds 1 year; b) erred on facts in equating the income from services with sale of goods based on the incorrect premise that performance of the Appellant is complete on signing of the subscription services agreement; and c) erred on facts in not appreciating that the Appellant is solely responsible for provision of services during the term of the subscription services agreement.

2.4 The Ld. AO and Hon'ble DRP erred on facts and in law in preponing the income to the current year, without appreciating that the books of accounts are duly audited and unqualified by the auditor, and the said income is offered to tax in the respective year in which it is accounted, thereby, it is revenue neutral;

2.5 Without prejudice to the above, the Ld. AO and Hon'ble DRP erred in not granting a corresponding deduction/relief of 1NR 18,28,95,584 on the preponment of income, for a corresponding increase in expenses in the nature of 'royalty' and 'service fees' payment as per the terms of the 'License and Service' agreement entered into by the Appellant with the AE and in view of the matching concept of accounting; Other grounds Red Hat India Private Limited 4

2.6 The Ld. AO erred in not considering the total income as per the revised return of income filed by the Appellant on 15 March 2016; 2.7 The Ld. AO erred in short granting credit of Taxes Deducted at Source to the extent of Rs. 5,55,907 while computing the tax liability for the year; 2.8 The Ld. AO erred in not granting credit of advance tax paid amounting to Rs. 2,42,00,000 while computing the tax liability for the year; 2.9 The Ld. AO erred on facts and in law in levying the interest under section 234B of the Act; 2.10 The Ld. AO erred on facts and in law in initiating penalty proceedings under section 274 read with section 271(l)(c) of the Act. The Appellant craves leave to add to, or alter, by deletion, substitution, modification or otherwise, the above grounds of appeal, either before or during the hearing of the appeal.

1.1. Business profile • Red Hat US is a provider of open-source solutions for internet computing; • An open source software typically grants every user free access to the source code and enable the customers to modify and customize the software to suit their requirements, unlike a proprietary software where source codes are owned by developers; # • Once an open source software is downloaded, software users may require access to ongoing support services; • The sale of 'Red Hat subscriptions' enable the customers to directly avail and access 24*7*365 support service from various support centres of Red Hat Group located in US, UK, Asia, Australia, Czech Republic, Africa, Russia and various language specific countries; • The Appellant enters into an Enterprise Agreement with the customers and distributes the open source 'Red Hat subscriptions'; • Further, the Appellant provides Red Hat software training content to the customers/ Red Hat training partners for which Red Hat US offers various training courses, renders consultancy services for the application of the systems, etc.; • Based thereon, the Appellant sub-contract services to Red Hat US vide a 'License and Service Agreement', pursuant to which the Global support service centres of Red Hat provide support services directly to customers; • The abovementioned business activities can be classified under the following two segments o Subscription segment -Appellant sells Red Hat service offerings to customers in India; o Services segment - Appellant provides Red Hat training content to customers in India, Alongside, offers training and certification courses, etc. • In consideration for such services, the Appellant compensates Red Hat US with: o royalty for use of intellectual property (trademark/ trade name); and o service fees for provision of support services directly to customers • In addition to the above, the Appellant renders sales & marketing and software support service to AEs

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International transaction Transfer pricing policy Methodology

Payment of royalty - Use of Royalty @ 3% TNMM- intellectual property (trademark/ • Subscription segment trade name) (comparable engaged in trading of software products) • Service segment (comparable Payment of service fee - RH1PL pays service fee to AE engaged in providing comparable Provision of support services after recovering its entire cost services) from Global support centres to along with an assured margin of Appellant's customers 1.4% for subscription and 13.5% for services segment

Cost+ 15% Provision of software support TNMM - Comparable engaged in service rendering similar services

Cost + 5% Provision of sales & marketing TNMM - Comparable engaged in support service rendering similar services 1.2 Benchmarking methodology adopted in the TP Study 1.3 Actions of Ld. TPO and Hon'ble DRP

During the course of assessment proceedings, the Ld. TPO, as confirmed by Hon'ble DRP, made an adjustment to the income of the Appellant on account of the following: • Disallowed the entire payment of service fees while alleging: o payment of 'service fees" as a payment of "royalty'; and o without prejudice, the support services are provided by AE to the Appellant i.e. services in the nature of intra-group services, for which there is no proof of any services being rendered • Proposed an adjustment under the sales & marketing support service segment and software support segment In this respect, the Appellant wishes to place its arguments as under: Ground 1.1 - 1.3: Adjustment on account of payment of service fees

2.1. Covered matter in preceding years i.e. AY 2012-13 & AY 2013-14 "

The Appellant wishes to submit that Hon'ble ITAT in Appellant's own case of AY 2012-13 and AY 2013-14, on identical facts, has deleted the entire adjustment on account of payment of service fees. There has been no change in the functions, assets, and risk profile of the Appellant in the impugned year and preceding two years. In this respect, the Appellant wishes to place reliance on the Hon'ble Mumbai ITAT judgment in its own case: • AY 2012-13 - • AY 2013-14-ITA No. 727I/Mum/2017

The relevant extract of the Hon'ble Mumbai ITAT Judgment in Appellant's own case of AY 2012-13 & AY 2013-14 is provided below:

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'28. Upon careful consideration, we find that the actual payment for royalty and serivce fees both under subscription and services segment are as per the agreement entered into between the assessee and its AE, No fault in the computation thereof has been pointed by the Revenue. Only due to error entire payment was booked under royalty. The sole basis on which the adjustments has been made is that the entire payment has been booked under royalty and the difference between the royalty as per the agreement and the total amount paid has been disallowed by the Revenue Authorities. We find that this is totally de hors the substance of the transactions. It is settled law that it is the substance that counts and not the nomenclature given by the party. In this situation, the disallowance/ adjustment made by the TPO confirmed by the DRP is without any application of mind and the same cannot be sustained. Moreover, the assessee's claim has been duly supported b}' the certificate from the statutory auditor which has also been ignored by the authorities below, without assigning any reason for the same. In these circumstances, we are oj the considered opinion that the transfer pricing adjustment of INR 23,52,26,045 for AY 2012-13 and INK 27,70,02,848 for AY 2013-14 is unjustified and deserves to be deleted. We order accordingly.

2.2. Non-grant of relief in the final assessment order The Appellant wishes to submit that the Assessing Officer has erred in not considering the binding directions of the Hon'ble DRP in the final order, wherein Akshay Software Technologies Limited has been reinstated as a comparable in the final set.

In view of the directions of the Hon'ble DRP, the net cost plus mark-up of 15% earned by the Appellant for the provision of software support services falls within the +/-3% of arm's length price earned by comparable companies as per the proviso to Sec 92C(2) of the Income Tax Act 1961.

The Appellant had filed an Appeal Effect Application before the Ld. TPO pursuant to DRP directions dated October 24, 2018(Refer Page 337 of Paper-book /)and then a Rectification Application and a follow-up thereon (Refer Page 379 and Page 417 of Paper-book I), wherein the Appellant had requested following the DRP directions, the adjustment on account of provision of software support services.

Red Hat India Private Limited 7 The arm's length net cost plus mark-up ('NCP') of the final selected 6 comparable companies is provided below for your ready reference: Name of Comparable company NCP(%) s AY 2014-15 No. CG-VAK Software & Exports Limited 9.38 1 2 Sasken Communications Limited 10.28 3 Kelton Tech Solutions Limited 19.72 4 Infobeans Technologies Limited 40.52 5 Ingenuity Technologies Limited 24.79 6 Akshay Software Technologies Limited (Upheld by DRP) 1.84 Arithmetic mean 17.75% The NCP earned by the Assessee under the software development segment is provided below: Particulars NCP (%) +3% Revenues 243,139,883 250,434,079 Total Revenues 243,139,883 250,434,079

Employee and other employee costs 211,425,985 211,425,985 Total operating expenses 211,425,985 211,425,985

31,713,898 39,008,094 Net Profit / Loss

15.00% 18.45% Operating Margin Based on the above results, NCP of 15% earned by the Assessee for the provision of software development service falls within the +/- 3% of the arm's length price i.e. NCP of 17.75% earned by comparable companies. Accordingly, the same is consistent with the arm's length standard from an Indian Transfer Pricing perspective. Accordingly, no adjustment Js warranted as the same_ is consistent with the arm’s length standard from an India transfer pricing perspective.

Red Hat India Private Limited 8 In addition to the above, the detailed arguments on merit are attached as Annexure 2.

Ground 1.6: Adjustment on account of provision of sales & marketing support services During AY 2014-15, the Appellant was engaged in providing sales & marketing support services, for which it was remunerated at a cost plus mark-up of 5%. The Ld. TPO, as confirmed by the Hon'ble DRP, computed the arm's length mark-up at 10.78% and made an adjustment of INR 2,034,038. In this respect, the Appellant wishes to place its arguments, as under: 2.3. Appellant's arguments on rejection/selection of comparables S. Comparable Appellant’s contention No Comparable proposed to be selected by Ld. TPO

Outsources services to third party vendors 1 Axis Integrated Axis is engaged in providing services by way of Systems Limited outsourcing the services to third party vendors. The same ('Axis') can be inferred from the significant commission expense (Refer Page 276 of incurred during the impugned year which accounts for the Appeal Set) 58.28% .of the other operating expenses: Particulars Amount

Commission Paid (A) 19,933,443

Total expenses (B) 34,202,921

A/B 58.28% judicial pronouncements supporting the contention of the Assessee that a company engaged in providing agency services by way of outsourcing the services to third party vendors is not comparable to a company operating through its own employees * BNY Mellon International Operations (India) Private Limited vs DCIT[ITA No.23/PN/2014] * Google India Pvt. Ltd. vs DCIT [ITA No. 1368/Bang/2010] * Belkin India Private Limited vs ACIT [ITA No.2292/Del./20!7] * Functionally dissimilar Axis is engaged in the business of trading digital signatures. Further, Axis is also engaged in providing

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Liasioningservices in the area of service tax, excise, foreign trade policy licensing, duty free credit entitlement certificates, etc.

Uses proprietary tool

Axis develops and owns unique intellectual property tool 'Axis Mine'. Judicial Pronouncements supporting exclusion of companies deriving significant benefit from proprietary process: • Rolls Royce Marine India Pvt. Ltd (ITA No.1384/Mum/2014) • Global Logic India Pvt Ltd vs DCIT (ITA No 122/Del/2013) • Capita India Pvt Ltd vs ACIT (ITA No 356/Mum/2016) • Genyme India Private Limited (ITA No, 892/DEL/2014) • Axis rejected as a comparable Reliance placed on Li & Fung India Private Limited (ITA No. 7549/DEL/2017) Comparable proposed to be rejected by Ld.TPO

2 • EDCIL (India) Ltd DRP Directions ('EDCIL') EDCIL is a government owned company. The FAR of (Ld. TPO rejected this company cannot be compared to the private this comparable business under normal circumstances because the prime solely on the motive of government companies is not to maximize ground of being a profits. Placed reliance on judgement of Hon'ble ITAT Government in the case of TP-Shell India Markets, Company) • Functionally similar (Refer Page 283 of EDCIL is primarily engaged in providing services in the the Appeal Set} nature of feasibility studies, training, management services, recruitment services, strategic consultancy, etc. For the purpose of analysis, the 'technical assistance and 'human resource development1 departments have been considered as comparable by the Appellant. • EDCIL selected as a comparable Reliance placed on Eli Lily Co. (India) Pvt. Ltd. (ITA No. 788/De1/2015); Gohlman Sachs (India) Securities Pvt. Ltd. (ITA No. 7724/Mum/2011) • Government company can be considered as a comparable Reliance placed on Vishay Components India P Limited (ITA No. 133/PN/I1)

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3 India Tourism • DRP Directions Development ITDC is a government owned company. The FAR of Corporation this company cannot be compared to the private ('ITDC') business under normal circumstances because the prime (Ld. TPO rejected motive of government companies is not to maximize this comparable profits. Placed reliance on judgement of Hon'ble ITAT solely on the in the case of TP-Shell India Markets. ground of being a • Functionally similar Government ITDC 'Anns and Misc. operations' segment should be Company) considered as comparable. This segment is engaged in (Refer Page 287 of providing event management services the Appeal Set) • ITDC selected as a comparable Reliance placed on Eli Lily Co. (India) Pvt. Ltd. (TS - 573-ITAT-2015(DEL) - TP) • Government company can be considered as a comparable Reliance placed on Vishay Components India P Limited (ITA No.133/PN/11)

• 4 Concept Public Functionally similar Relations India Concept is primarily engaged in providing information Limited ('Concept services and consultancy services. The company is Public') engaged in providing consultancy in the nature of (Ld. TPO rejected development and marketing information based services. the company on the As per the 'Overview of the company' as provided in the basis that it is annual report, the company earned of its income from engaged in media building images and marketing the product/ a brand of and the company. communication sector) On perusal of the company's official website, it is seen (Refer Page 282 of that Concept Public is in engaged in providing the Appeal Set) marketing services through image enhancement and promoting the product or brand of the company thereby, broadly similar to support functions of the Appellant. • Impresario 5 Functionally similar Event Impresario India caters to the business needs of sales Management promotions, road shows, product launches, exhibitions, India Limited trade shows, sports events, musical nights, MICE events ('Impresario and many more such services. On perusal of the India') company's official website, it was observed that (Ld. TPO has Impresario India has conducted events of various rejected the magnitudes like corporate event, conferences, seminars, company on the trade shows, stage shows, corporate events/meetings, basis that it is etc. As per the break-up of 'revenue from operations" engaged in event provided in Note -26 of the annual report, the company management) earned majority of its income from provision of event (Refer Page 290 of co-ordination services. the Appeal Set)

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Judicial precedent supporting event management company as comparable to marketing support service provider: • Genzyme India Pvt Ltd [ITA 892/DEL/2014] • Eli Lily Co. (India) Pvt. Ltd. (ITA No. 788/Del/2015)

• 6 Kestone DRP Directions Integrated The company derives its income from event Marketing management services, managed manpower services, Services Private infrastructure services etc. The company is therefore not Limited found comparable. ('Kestone') • Functionally similar (Ld. TPO has The company operates in the following segments: ^ rejected the Managed manpower services ^ Infrastructural services company due to unavailability of • Event management services current year • Others data) For the purpose of the analysis, the 'Event (Refer Page 292 of management services' segment has been considered the Appeal Set) comparable by the Assessee. In the said segment, Kestone is engaged in arranging conferences, exhibit ions and trade shows. Thus, 'Event management services' division pertains to business support services, and has been considered as comparable by the Assessee. Judicial precedent supporting event management company as comparable to marketing support service provider: • Genzyme India Pvt Ltd [ITA 892/DEL/2014] • Eli lily Co. (India) Pvt. Ltd. (ITA No. 788/Del/2015)

2.4. Arguments for working capital adjustment to be allowed to the Appellant The amount of capital required to support business functions varies greatly, because of the level of debtors and creditors. The effect on profits from investing in different levels of working capital must be taken into account.

Rule 10B(l)(e) and Rule 10B(3) of the Rules requires the difference between controlled and uncontrolled transactions should be taken into account for which necessary adjustments shall be made. OECD guidelines also points out the need to adjust comparables and the requirement for accuracy and reliability. The above is also supported by various judicial precedents, mentioned below, wherein it has been held that the working capital adjustment should be carried out to bring two otherwise comparable cases at par with each other. • Nortel Networks India Private Limited v/s ACIT (ITA No. 4765/DEL/2011 & ITA 427/DEL/2013) • TNT India Private Limited vs. ACIT (ITA No. 1442 {BNG}/ 08) • Federal Mogul Anand Bearing India Limited vs. DCIT (ITA No. 463/Mum/2016)

Red Hat India Private Limited 12 • DCIT vs. Exedy India Limited (ITA no.897/Mum/2018) • Income Tax Office vs. Smarsh India Private Limited (IT(TP)A No.847/Bang/2013) • I apian India Pvt. Ltd. vs. ITO (ITA No.-1481/Del/2015)

Red Hat India Private Limited 13 Referring to above Ld. Counsel of the assessee has requested the entire assessment order to be quashed as such. Upon careful consideration, we are not at all in the agreement with the submission of the Ld. Counsel of the assessee that when a direction of the DRP is not followed on one of the issues the entire assessment order dealing with the several issues is liable to be quashed. It is settled law that there cannot be a disproportionate retribution. In this view of the matter, we are of the opinion that since, the AO has not followed the direction of DRP, the adjustment on account for provision of software support services is not sustainable and same is liable to be deleted. Accordingly, we direct the adjustment in this regard is to be deleted.

S. Comparable Appellant’s contention No Comparable proposed to be selected by Ld. TPO

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Outsources services to third party vendors 1 Axis Integrated Axis is engaged in providing services by way of Systems Limited outsourcing the services to third party vendors. The same ('Axis') can be inferred from the significant commission expense (Refer Page 276 of incurred during the impugned year which accounts for the Appeal Set) 58.28% .of the other operating expenses: Particulars Amount

Commission Paid (A) 19,933,443

Total expenses (B) 34,202,921

A/B 58.28% judicial pronouncements supporting the contention of the Assessee that a company engaged in providing agency services by way of outsourcing the services to third party vendors is not comparable to a company operating through its own employees * BNY Mellon International Operations (India) Private Limited vs DCIT[ITA No.23/PN/2014] * Google India Pvt. Ltd. vs DCIT [ITA No. 1368/Bang/2010] * Belkin India Private Limited vs ACIT [ITA No.2292/Del./20!7] * Functionally dissimilar Axis is engaged in the business of trading digital signatures. Further, Axis is also engaged in providing Liasioningservices in the area of service tax, excise, foreign trade policy licensing, duty free credit entitlement certificates, etc.

Uses proprietary tool

Axis develops and owns unique intellectual property tool 'Axis Mine'. Judicial Pronouncements supporting exclusion of companies deriving significant benefit from proprietary process: • Rolls Royce Marine India Pvt. Ltd (ITA No.1384/Mum/2014) • Global Logic India Pvt Ltd vs DCIT (ITA No 122/Del/2013) • Capita India Pvt Ltd vs ACIT (ITA No 356/Mum/2016) • Genyme India Private Limited (ITA No, 892/DEL/2014)

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• Axis rejected as a comparable Reliance placed on Li & Fung India Private Limited (ITA No. 7549/DEL/2017)

We find cogency in the above submissions, which are duly supported by the case laws. Hence, we direct that this comparable should be removed from the final set of comparables. The AO should make computation accordingly.