M/S. ISG NOVOSOFT TECHNOLOGIES LIMITED,BANGALORE vs. DEPUTY COMMISSIONER OF INCOME TAX, CIRCLE- 3(1)(1), BANGALORE

The grounds raised in the appeal by the Assessee are with regard to determination of Arm’s Length Price (ALP). As far as the issue of determination of ALP of international transactions carried out by the assessee with its Associated Enterprise (AE) is concerned, the same is in respect of Information Technology Enabled Services (ITeS). During the previous year, the assessee rendered Information Technology Enabled Services [ITES] to its AE. As required under the provisions of section 92 of the Income Tax Act, 1961 (Act), income arising from international transaction with AE has to be computed having regard to the arm’s length price [ALP].

The Assessee filed a Transfer Pricing Study (TP Study) to justify the price paid in the international Transaction as at ALP by adopting the Transaction Net Margin Method (TNMM) as the Most Appropriate Method (MAM) of determining ALP. The Assessee selected Operating Profit/Operating Cost (OP/OC) as the Profit Level Indicator (PLI) for the purpose of comparison. The OP/OC of the Assessee was arrived at 17.48% by the Assessee in its TP study. The operating income was Rs.94,37,10,000/-and the Operating Cost was Rs.80,32,95,000/-. The Operating profit (Operating income – Operating cost was Rs.14,04,15,000/-. Thus the OP/TC was arrived at 17.48%. The Assessee chose companies who are engaged in providing similar services such as the Assessee. The Assessee identified companies whose average arithmetic mean of profit margin was comparable with the Operating margin of the Assessee. The Assessee therefore claimed that the price it charged in the international transaction should be considered as at Arm’s Length.

The Transfer Pricing Officer (TPO) to whom the determination of ALP was referred to by the AO, accepted TNMM as the MAM and also used the same PLI for comparison i.e., OP/TC. He also selected comparable companies from database. The TPO on his own identified companies as comparable with the Assessee company and worked out the average arithmetic mean of their profit margins as follows:

The Assessee filed objections before the Disputes Resolution Panel (DRP) against the draft assessment order passed by the AO wherein the addition suggested by the TPO as adjustment to ALP was added to the total income of the Assessee by the AO. The DRP gave certain directions to exclude 3 comparable companies chosen by the TPO. Based on the directions of the DRP, the AO passed the final order of assessment. To the extent the Assessee did not get relief from the DRP, the Assessee preferred appeal before the Tribunal.

In the result, the appeal of the assessee stands allowed for statistical purposes.

Further vide its order in M.P. No. 250/Bang/2017 in IT (TP) A No. 244/Bang 22017 dated 15.12.2017, the Hon'ble ITAT Bangalore gave the following direction:- We have considered the rival submissions. We find that at the time of hearing of the appeal, the Id. AR of assessee has filed a chart and the appeal was heard on the basis of chart. In the said chart, the contentions are raised regarding margin computational error in the respect of two comparables i.e., Accentia Technologies Ltd. and e4e Healthcare Business Private Limited and for the remaining four comparables, the only contention raised was regarding turnover filter and there is no contention raised regarding the functionality aspect. Hence on this aspect, we find no apparent mistake in the impugned Tribunal order because it appears that no argument was made in respect of this aspect. Regarding the second aspect i.e. regarding Foreign Exchange fluctuation gain/loss, in the chart, several judgements are cited by id. AR of assessee but in the impugned Tribunal order although ground no. 9 is reproduced by the Tribunal on page no. 4 of the Tribunal order, there is no decision on this aspect and therefore, this is an apparent mistake in the impugned Tribunal order. I-fence we decide this aspect as per ground no. 9 raised before the Tribunal. We find that the details regarding foreign gain/ loss is not available on record as to whether the gain/loss is in respect of turnover of the present year or it is in respect of the turnover of an earlier year. In respect of computation of ALP, profit margin percentage is worked out by IT(TP)A No.2632/Bang/2019 Page 6 of 12

On objection by the Assessee to the order of the TPO/AO the DRP excluded BNR Udyog Ltd., from the list of comparable companies. Therefore only 6 out of the 10 comparable companies remained as comparable companies after the order of the DRP. In this appeal the Assessee seeks only two reliefs viz., (i) exclusion of two comparable

As far as excluding the companies on the basis of turnover is concerned, the issue has been settled in several decisions of the Tribunal and has been elaborately discussed by this Tribunal in the case of Autodesk India Pvt. Ltd. v. DCIT in IT(TP)A No.540 & 541/Bang/2013, order dated 06.07.2018. The Tribunal in this decision after review of entire case laws on the subject, considered the question, whether companies having turnover more than 200 crores upto 500 crores has to be regarded as one category and those companies cannot be regarded as comparables with companies having turnover of less than 200 crores, the Tribunal held as follows:-

In the light of the aforesaid decision of the Tribunal, we exclude the two comparable companies Infosys BPO Ltd., and TCS e-Serve Ltd. (having turnover of Rs.1312.14 Crores and Rs.1578.44 Crores respectively) by application of the turnover filter. The Assessee’s turnover is only Rs.94 crores (less than 100

As far as Gr.No.2(d) is concerned, the same is with regard to grant of negative working capital adjustment. With regard to this ground regarding grant of negative working capital, the ld. counsel for the assessee has placed reliance on the decision of the coordinate Bench in the case of DCIT v. M/s. Software AG Bangalore Technologies P. Ltd., IT(TP)A No.1628/Bang/2014, order dated 31.03.2016 wherein it was held that negative working capital should not be computed and adjusted. The ld. DR relied on the decision of the Coordinate Bench in the case of Technotree Convergence P. Ltd. v. DCIT in IT(TP)A No.1616/Bang/2017, order dated 27.06.2018 wherein it was held that negative working capital should be allowed.

On this issue, we are of the view that working capital adjustment is made for the time value of money lost when credit period is given to customers. It is the submission of the ld. counsel for the assessee in this case that the assessee is a captive unit which is entirely funded by the AE. The assessee has no borrowings and is fully compensated by the parent on a total cost plus. The assessee has no working capital risk - in other words, it is a risk-insulated service provider to the parent. The only customer of the company is its parent company. The ld. counsel for the assessee has relied on a host of ITAT decisions, the main decision being that of M/S. Software AG Bangalore Technologies Pvt. Ltd.(supra) which in turn has relied on the decision of ITAT Hyderabad in the case of Adaptec (India) Private Limited and contended that no negative working capital adjustment is called for. The ld.DR’s reliance is on the decision in the case of Technotree Convergence P. Ltd. (supra) wherein it was held that negative working capital adjustment has to be allowed.

Comparables chosen operate under varied economic conditions. Therefore, while comparing a company to that of similar companies, it is necessary to undertake comparability adjustments. Balance sheet adjustments are intended to account for IT(TP)A No.2632/Bang/2019 Page 10 of 12 different levels of inventories, receivables, payables, interest rates etc. The most common balance sheet adjustments made to reflect different levels of accounts receivable, account payable and inventory are known as working capital adjustments. As mentioned by the OECD, comparability adjustments should not be performed on a routine or mandatory basis but rather on a case by case basis depending on the facts and circumstances. Economic rationale of Working capital of a business is the capital used in its day-to-day trading operations. Working capital is affected by numerous business incidences. It is very common for tested party and each of the potential comparables to differ materially in the amount of working capital (inventory, accounts receivables and payable). Such differences are mainly caused due to differences in the terms of purchase and sale, levels of inventory etc. For example: If the business advances a trade credit of (say) 60 days, its cash gets locked up for 60 days and reduces the working capital. It will have to borrow from open market to meet its working capital requirement, and hence incur expenses. Similarly, if it avails of trade credit of 60 days, it has surplus cash at its disposal. It will need to borrow less money to fund operational requirements. Hence, working capital position affects the additional cost incurred by a business by way of interest on borrowing from the open market. Working capital adjustments seeks to adjust for the differences in time value of money between tested parties and potential comparables with an assumption that differences should be reflected in profits Working capital adjustment has a strong rationale in economic theory. It facilitates to increase the comparability between the tested party and comparables working in an industry which is competitive. Working capital adjustment can work out to be positive or negative. A positive working capital adjustment (WCA) will tend to reduce the arm’s length PLI while a negative WCA will tend to increase the arm’s length PLI.

We find that the facts of the Assessee’s case are similar to that of the case of the Bangalore ITAT in the case of M/S.Software AG Bangalore Technologies Pvt.Ltd. and therefore we are inclined to delete the negative working capital adjustment. In IT(TP)A No.2632/Bang/2019 Page 11 of 12 determining ALP under TNMM, the correct approach would be to look at the costs incurred by the assessee only and should not impute any additional cost as done by TPO, which indirectly enhances the ALP artificially. The contrary view expressed in decision cited by the learned DR takes the view that Working capital adjustment is required in all cases as any credit extended to customers will result in cash locked up and will result in the assessee borrowing money from the banks and incur additional cost towards interest on these borrowings which cost will have effect on the price charged. It is the reasoning in these decisions that under TNM method that every ingredient of profit margins of comparable companies are analysed, whether it is positive or negative. The decision proceeds on the basis of effect on price owing to working capital requirement. We are of the view that working capital adjustment itself is computed on the basis of outstanding current assets and liabilities at the year end. It means that other things being equal, an entity having higher working capital will incur more interest cost which will reduce profitability. Hence no importance shall be given to pricing aspect. Since the assessee does not have any working capital risk, the question of negative working capital does not arise.

The TPO is directed to compute the ALP in the light of the directions as given above, after affording Assessee opportunity of being heard. No other grounds were pressed for adjudication except the aforesaid two issues.

In the result, appeal of the Assessee is partly allowed.