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Income Tax Appellate Tribunal, “B” BENCH : BANGALORE
Before: SHRI N.V. VASUDEVAN & SHRI B R BASKARAN
Per N.V. Vasudevan, Vice President IT(TP)Appeal No.403/Bang/2016 is an appeal by the Revenue while IT(TP)A.No.698/Bang/2016 is an appeal by the Assessee. Both these appeals are directed against the order dated 28.01.2016 of ITO, Ward- 6(1)(1), Bangalore (hereinafter referred to as the Assessing Officer, “AO” in short) passed u/s.143(3) read with Section 144C(13) of the Income Tax Act, 1961 (Act) in relation to assessment year 2011-12.
The Assessee in engaged in the business of provision of Software Development Services (SWD services), to its wholly owned holding company. In terms of the provisions of Sec.92-A of the Act, the Assessee and its wholly owned holding company were Associated Enterprises ("AEs"). In terms of Sec.92B(1) of the Act, the transaction of providing SWD Services was an “international transaction” i.e., a transaction between two or more associated enterprises, either or both of whom are non- residents, in the nature of purchase, sale or lease of tangible or intangible property, or provision of services, or lending or borrowing money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises, and shall include a mutual agreement or arrangement between two or more AEs for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any one or more of such enterprises. In terms of Sec.92(1) of the Act, the Any income arising from an international transaction shall be computed having regard to the arm’s length price. In this appeal by the Assessee, the dispute is with regard to determination of Arms’ Length Price (ALP) in respect of the aforesaid two international transaction of (i) rendering SWD services to IT(TP)A Nos. 403 & 698/Bang/2016 Page 3 of 17 the AE and (ii) rendering of MSS to the AE. We shall deal each of the international transactions separately.
As far as the provision of Software Development services are concerned, 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 Assessee chose companies who are engaged in providing similar services such as the Assessee from the Prowess and Capitaline Plus Data Base. The Assessee identified 13 companies whose average arithmetic mean of profit margin was 13.71% which was less than and comparable to 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 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/OC. He also selected comparable companies from the same database from which the Assessee had chosen comparable companies, viz., Prowess and Capitaline Plus. The TPO rejected many of the comparable companies chosen by the Assessee as comparable companies. The TPO on his own identified some companies as comparable with the Assessee company and worked out the average arithmetic mean of their profit margins as follows:-
IT(TP)A Nos. 403 & 698/Bang/2016 Page 4 of 17
The TPO computed the Addition to total income on account of adjustment to ALP as follows:-
Computation of arm's length price by TPO and the adjustment made
Arm's Length Mean Margin on cost 24.82% Less: Working Capital Adjustment -1.52% Adjusted mean margin of the comparables 26.34% Operating Cost Rs. 107,84,88,123/- Arm's length Price (126.34% of Operating Cost) Rs. 136,25,61,895/- Price Received Rs.128,03,26,675/- Short fall being adjustment u/s. 92CA Rs.8,22,35,220/- Thus a sum of Rs.8,22,35,220/- was added to the total income of the Assessee on account of determination of ALP for provision of SWD services by the Assessee to its AE.
The Assessee filed objections before the Disputes Resolution Panel (DRP) against the draft assessment order passed by the AO wherein the IT(TP)A Nos. 403 & 698/Bang/2016 Page 5 of 17 addition suggested by the TPO as adjustment to ALP was added to the total income of the Assessee by the AO. The DRP excluded 6 comparable companies viz.,(i) Infosys Ltd., (ii) Larsen & Toubro Ltd., (iii) Mindtree Ltd., (iv) Persistent Systems Ltd., (v) Sasken Communication Technologies Ltd., and (vi) Tata Elxsi Ltd., on the application of turnover filter of more than Rs.200 crores. The DRP did not agree to plea of the Assessee for exclusion of Acropetal Technologies Ltd., E-Infochips Ltd., ICRA techno Analytics Ltd., Persistent Systems & Solutions Ltd., and E-Zest Solutions Ltd., To the extent the Assessee did not get relief from the DRP, the Assessee has preferred appeal before the Tribunal. The specific grounds of challenge are contained in Grd.No.10 of the grounds of appeal filed before the Tribunal. The grounds relating to SWD services segment that were pressed for adjudication were Ground No. 10 in which the Assessee has projected grievance with regard to non-exclusion of the following five companies by the DRP viz., of Acropetal Technologies Ltd., E-Infochips Ltd., ICRA techno Analytics Ltd., and E-Zest Solutions Ltd. In Gr.No.12 the Assessee has projected its grievance regarding the action of the DRP in not giving proper directions regarding working capital adjustment. The ground of appeal of the Assessee in this regard reads as follows:
“12. The learned AO/learned TPO/Hon'ble DRP has erred in making the following errors in the computation of working capital adjustment: a. by not considering the fact that the Appellant does not have any working capital risk, therefore, no negative working capital adjustment should be allowed. b. in proposing a restriction to the working capital adjustment without giving any cogent reason. c. in considering the wrong SBI PLR while computing the working capital adjustment.”
IT(TP)A Nos. 403 & 698/Bang/2016 Page 6 of 17
As far as the appeal by the revenue is concerned, Gr.No.1, 4 and 5 are general and need no specific adjudication. The ground of appeal of the revenue in relation to Transfer Pricing issue is projected in Gr.No.2 which reads as follows:-
2. On the facts and in the circumstances of the case, the Dispute Resolution Panel erred in granting 1% risk adjustment arbitrarily without appreciating the facts of the case and its comparables.
As far as Gr.No.2 of the revenue’s appeal is concerned, the same is in relation to the action of the DRP in allowing claim of the Assessee for allowing risk adjustment while determining ALP. A perusal of the order of the DRP in this regard shows that the DRP has not directed the AO to allow risk adjustment @ 1%, but has only directed the AO to decide the percentage of risk adjustment to be calculated and to take guidance from the decision of the ITAT Bangalore in the case of Hellosoft Pvt. Ltd. [2013] 32 taxmann.com 101 ITAT Hyd. Nevertheless there is no basis or discussion on what are the risks and its quantification. Hence, we are of the view that the said direction is not in accordance with law and hence Gr.No.2 raised by the revenue is allowed, in the facts and circumstances of the present case.
As far as Gr.No.10 raised by the Assessee is concerned, the learned counsel for the Assessee brought to our notice decision of Bangalore ITAT in the case of M/S.LG Soft India Pvt. Ltd. Vs. DCIT IT(TP)A o.52/Bang/2016 for AY 2011-12 order dated 5.8.2020. In the aforesaid decision, the Assessee was also a SWD service provider and the very same comparable companies were chosen as comparable companies in that case. The Tribunal ruled on the comparability of 7 companies with a SWD service provider such as the Assessee in which the aforesaid 5 companies sought to be excluded in this appeal by the Assessee was also IT(TP)A Nos. 403 & 698/Bang/2016 Page 7 of 17 a part. The following were the relevant observations of the Tribunal for excluding the aforesaid 5 companies listed in paragraph-6 above :-
“10. With regard to the other 7 comparable companies, whose exclusion is challenged by the revenue in ground No.2 of its appeal, we find that exclusion of these comparables from the list of companies selected by the TPO had come up for consideration before the Bangalore ITAT in the case of Electronic for Imaging (I) Pvt. Ltd. v. DCIT [2017] 85 taxmann.com 124 [Bang. Trib]. ; Symantech Software & Services (I) Pvt. Ltd. v. DCIT, DCIT v. Ikanos Communication Pvt. Ltd. in ITA 137/Bang/2015; Ness Technologies (I) Pvt. Ltd. v. DCIT in ITA No.696/Mum/2016 which are also decisions rendered in relation to AY 2011-12 in the case of a companies providing SWD services such as the assessee in the present appeal. It is also relevant to point out that the very same comparable companies chosen by the TPO in the present appeal had been chosen by the TPO as comparable companies in the case of Electronic for Imaging (I) Pvt. Ltd. (supra). The Tribunal in its order dated 14.7.2017 in the aforesaid case dealt with the comparability of these companies. As far as Acropetal Technologies Ltd. is concerned, vide 11. para 8 of the order of Tribunal in Electronics for Imaging (I) Pvt. Ltd. (supra), exclusion of Acropetal was upheld on the ground that this company was into development of computer products. The Tribunal also held that L&T Infotech Ltd. had RPT at 18.66% and since the RPT was beyond the threshold limit of 15%, this company was directed to be excluded from the list of comparable companies. The Tribunal further excluded Tata Elxsi Ltd. from the list of comparables on the ground that this company was engaged in diversified activities and was not a pure SWD services provider such as the assessee. In para 9 of the aforesaid order, the Tribunal held e-Infochips Ltd., was earning revenue both from the software services and software products and though the break-up of revenue from the two segments were available, but the break-up of Operating Cost and Net Operating revenue and segmental details were not available.
12. As regards e-Zest Solutions Ltd., in the case of Symantech Software & Services (I) Pvt. Ltd. v. DCIT, ITA
IT(TP)A Nos. 403 & 698/Bang/2016 Page 8 of 17 No.614/Mds/2016, this company was held to be engaged in Knowledge Process Outsourcing (KPO) and cannot be regarded as a SWD services company.
The Tribunal in the case of DCIT v. Ikanos Communication Pvt. Ltd. in ITA 137/Bang/2015 excluded the company, ICRA Techno Analytics Ltd., on the ground that it was engaged in engineering and consulting services, besides licensing and sub-licensing and no segmental information was available to compare the margins of SWD services segment.
14. The Mumbai Tribunal in the case of Ness Technologies (I) Pvt. Ltd. v. DCIT in held Infosys Ltd. to be not comparable for the reason that this company was engaged in manufacturing of software products and was a giant company assuming various risks. As far as Larsen & Toubro Infotech Ltd., is concerned, vide paragraph-8 page-16 of the order in the case of Electronics for imaging India Pvt. Ltd., (supra) this tribunal excluded this company on the ground of presence of onsite revenue of more than 50% and that the related party transaction was more than 15% (18.66%).
15. Respectfully following the aforesaid decisions, we uphold the exclusion of the aforesaid 7 companies from the list of comparable companies and ground No.2 raised by the assessee to this extent is dismissed. We may add that the other grounds raised
by the revenue in its appeal are purely supportive of ground No.2 and are general grounds with no specific reference to instances of comparables excluded and hence dismissed.”
10. Respectfully following the aforesaid decision, we direct exclusion of the aforesaid 5 comparable companies from the list of comparable companies.
As far as Gr.No.12 raised by the Assessee is concerned, the facts are that the TPO computed working capital adjustment as per annexure-C to the order of Assessment. Perusal of the same shows that in respect of 13 comparable companies chosen by him, he had compared working capital requirements vis-à-vis the Assessee and arrived at working capital
IT(TP)A Nos. 403 & 698/Bang/2016 Page 9 of 17 adjustment of (-0.22%) + (-0.63%). In the order of assessment however he has discussed about his opinion that working capital adjustment cannot exceed the average working capital component of the comparables and he has referred to a figure of 1.63% being the upper ceiling limit of working capital adjustment which is the average working capital component of the comparables. He has also referred to the fact that while computing working capital adjustment, advances received from the sister company included in the debtors should be excluded because such advances received towards services to be rendered usually does not have any cost. Finally the TPO has concluded as follows: “Accordingly the working capital adjustment is restricted to 1.63% in this case and the working capital adjustment is arrived at -0.67%. In the computation of Arm’s Length, the TPO has adopted a figure of -1.52%. It is not clear from the order of the TPO as to how he arrived at a negative working capital adjustment of -1.52%. The figure of -1.52% adopted by the TPO is contrary to the calculation in “Annexure-C to the TPO’s order wherein the working capital adjustment has been arrived at (-0.22%) + (-0.63%).
Before the DRP, the assessee submitted that the TPO failed to appreciate the basic purpose of making the adjustment for working capital position. The purpose of working capital adjustment is to adjust for the differences in the time value of money between the assessee and the potential comparable companies with an assumption that the differences would be reflected in the profits. The TPO had derived the upper cap for allowing the working capital adjustment without providing any logical rationale. Any adjustment has to be made taking into account the difference in the comparable companies and the assessee's position. In this regard, reference was made to Rule 10C(3) of Income-tax Rules. 1962 ("the Rules"), which is as follows:-
IT(TP)A Nos. 403 & 698/Bang/2016 Page 10 of 17
"An uncontrolled transaction shall be comparable to an international transaction if : • there are no differences that materially affect price/margin; or • reasonably accurate adjustments to account for such differences can be made.” 13. Based on the above, it was contended that the TPO has adopted a methodology wherein the actual working capital position of the assessee had been completely ignored and arrived at a derived upper cap limit for working capital adjustment.
Further, the assessee also highlighted that the TPO has observed that the there is no cost associated with advances received from holding companies just because there were no debtors or inventory and therefore concluded that the cost of working capital towards such advances is zero. Accordingly, such advances are not considered in computation of working capital adjustment.
It was submitted that similar restriction on working capital adjustment was imposed by the TPO in the earlier AY 2009-10 which was ultimately rejected by the DRP on the ground that the TPO has no domain to force the assessee in funding its working capital requirement in a specific way. Based on the above, the assessee submitted before the DRP that the adjustment towards the working capital is to be carried out as per the approach suggested in the international guidelines and also submitted as follows:-
• The advances received from AEs to be included in computation of working capital adjustment irrespective of value of debtors or inventory; and IT(TP)A Nos. 403 & 698/Bang/2016 Page 11 of 17
• The assessee to be entitled for actual working capital adjustment without any upper cap. 16. The DRP however held as follows:
“The objection as above has been considered but is found to lack merit. The TPO's methodology for computing the net working capital was as under : Net Working Capital = Debtors + Inventory - Creditors Since the TPO has clearly outlined the methodology followed for computing working capital adjustment in which advances are not a part of the equation, there is little scope for the taxpayer to have such grievances. The TPO's methodology of calculating working capital adjustment is a standard method of such calculation which is also the method specified in the OECD guidelines of 1995 which considers trade receivables, inventory and trade payables as the three accounts to calculate a value for differences in levels of working capital between the tested party and the comparable to reflect the time value of money. The items requested for being factored in additionally by the tax payer are not part of the OECD's standard method of determining working capital adjustment. In fact some of these items such as unbilled revenue are, in fact, premature in this matter since the enforceable liability itself has not arisen in respect of these amounts. The tax payer's contentions are, therefore, found to be unacceptable. Since the taxpayer is a captive unit remunerated on cost plus basis the TPO understanding that the cost of working capital towards advances received from the AE is nil makes good sense. The upper cap based on the average cost of capital of the comparables is also considered reasonable and in the interest of protecting strict comparability in all facets which affect prices and profitability. The objections raised are, therefore, found to be unacceptable. The objections of the taxpayer regarding restriction have duly been considered. The reason for restriction of the working capital adjustment has been given in the TPO's order. The TPO has also given reasons for the non-inclusion of advances from AE's. Both
IT(TP)A Nos. 403 & 698/Bang/2016 Page 12 of 17 the reasons given by the TPO are found to be appropriate for purposes of TP analysis which requires that the attempt should be to ensure the maximum extent of comparability between the tested entity and the uncontrolled comparables. The TPO's approach ensures this. Hence, the objection raised by the taxpayer in this regard cannot be accepted.”
After hearing the rival submissions on this issue, we are of the view that there is no clarity on the several contradictions in the order of the TPO, which we have pointed out in the earlier paragraphs. There appears to be three grievances on the methodology of computing working capital adjustment. The first grievance is that when the working capital adjustment is positive, it should be allowed on actual without putting a cap on the working capital adjustment i.e., without restricting the working capital adjustment to the average working capital component of the comparables. The second grievance is that when the working capital adjustment is negative then there should be no adjustment on account of working capital. Third grievance is that advances received from AE should also be considered as part of payables in computing working capital of the Assessee. All the aforesaid three grievances projected by the Assessee are well founded and are supported by decisions rendered by Tribunals. The grievance of the assessee is with regard to negative working capital adjustment carried out by the TPO which was confirmed by the DRP is that Working capital adjustment is made for the time value of money lost when credit time is given to the customers. The Assessee however does not bear any risk and has no working capital contingencies. The Assessee has not incurred any expenses for meeting the working capital requirement. The Assessee is running the business without any working capital risk as compared to the comparables. The Assessee does not bear any market risk as the services are provided only to Tavant US. Therefore, requirement for adjustment of negative working capital does not arise. In the case of Tivo Tech Private Limited v. DCIT (order dated 12.06.2020 in IT(TP)A No.
IT(TP)A Nos. 403 & 698/Bang/2016 Page 13 of 17 1619/Bang/2017), Lam Research India Pvt Ltd v. DCIT (order dated 30.04.2015 in & 1385/2014) and DCIT v. Software AG Bangalore Technologies Pvt Ltd (order dated 31.03.2016 in ITA No. 1628/2014) passed by this Hon’ble Tribunal, it has been held that negative working capital adjustment shall not be made. Similarly when working capital adjustment is positive it should be allowed on actual without restricting the same to the arithmetic mean margin of working capital of the comparable companies. The grievance that advances received from AE should be considered as part of payables for computing working capital requirement is also a settled proposition. Since the issue has not been dealt with in proper perspective and there are factual contradictions, we deem it fit and appropriate to remand the issue of working capital adjustment to the TPO/AO for a consideration afresh after opportunity to the Assessee and in the light of the observations made in this order on working capital adjustment. No other specific grounds with regard to determination of ALP were argued or pressed.
As far as Grd.No.3 raised by the revenue is concerned, the same is with regard to exclusion of telecommunication expenses, insurance charges and foreign exchange loss both from the export turnover and total turnover for the purpose of computation of deduction u/s. 10A of the Act. It is not in dispute before us that the Hon’ble High Court of Karnataka in the case of CIT v. Tata Elxsi Ltd [2012] 349 ITR 98 (Karn) has held that charges/expenses relating to telecommunication, insurance charges and foreign exchange loss should be excluded both from export turnover and total turnover while computing deduction u/s.10A of the Act i.e., whatever is removed from the numerator should also be excluded from the denominator while working total turnover and export turnover for allowing deduction u/s.10A of the Act. The aforesaid decision of the jurisdictional High Court has been upheld by the Hon’ble Supreme Court in the case of IT(TP)A Nos. 403 & 698/Bang/2016 Page 14 of 17 CIT v. HCL Technologies Ltd. in Civil Appeal No.8489-98490 of 2013 & Ors. dated 24.04.2018. In view of the above, we are of the view that the order of AO calls for no interference.
Another corporate tax issue that remains for consideration in Assessee’s appeal is Gr.No. B 1 which reads as follows:- “B. Corporate tax 14. Disallowance of lease rentals claimed as revenue expenditure — Rs.14,965,386 a. The learned AO erred in law by disallowing lease rentals paid by the Appellant during Financial Year 2010-11. b. The learned AO erred in disallowing the lease rentals while passing the final order when the same was neither disallowed in the draft assessment order nor by the Hon'ble DRP. c. Notwithstanding and without prejudice to the above, the learned AO has erred in treating the lease rental payments made by the Appellant as capital expenditure. d. The learned AO has erred in not appreciating the fact that the Appellant has paid lease rentals towards fit-outs provided by the lessor. e. Notwithstanding and without prejudice to the above, the learned AO ought to have granted consequential allowance of depreciation should the claim of lease rental payments be treated as capital expenditure.”
In the earlier AY i.e., AY 2010-11, the assessee had taken a premise on lease and paid lease rent of Rs.3,79,39,583 which was debited to the P&L account. In the computation of total income, the assessee claimed deduction of a sum of Rs.1,64,45,484 towards fit-outs which is payable in EMIs over a period of 5 years which was not debited to the P&L a/c. The IT(TP)A Nos. 403 & 698/Bang/2016 Page 15 of 17 said sum was capitalized in the books as lease rentals. In the proceedings before the AO for AY 2010-11, the assessee submitted with regard to the aforesaid deduction as follows:- “I) Deduction on account of lease rentals paid during the year amounting to Rs.16,445,484 In this regard, the Company would like to submit that it has taken office premises on rent from Information Technology Park Limited (ITPL). The company has entered into a lease agreement with ITPL whereby ITPL has agreed to provide fit-outs to the rented premises as per the requirements of the Company. The lease rentals for such fit-outs shall be payable in equal monthly instalments for a period of five years after which the Company shall not be liable to pay any monthly rentals to ITPL on account of fit-out charges. The lease rentals paid to ITPL towards such fit-outs has not been debited to the profit and loss account. Accordingly. the Company has claimed the lease rental paid to ITPL amounting to Rs. 16,445,484 towards such fit-out charges as revenue expenditure in the computation of income. The copies of lease rental agreement are enclosed as Annexure 1.”
The AO, however, came to the conclusion that the payment was capital in nature and therefore cannot be allowed as a deduction. The same was accordingly added to total income of the assessee. The DRP on this issue concurred with the view of the AO that the expenditure in question was capital expenditure but however held that assessee can claim depreciation on the amount disallowed. On further appeal by the Assessee, the Tribunal remanded the issue to the AO for consideration afresh of the nature of expenses in the light of details of the expenses to be furnished by the Assessee.
In AY 2011-12 that is the Assessment Year which is subject matter of this appeal, the Assessee claimed depreciation on the Written Down
IT(TP)A Nos. 403 & 698/Bang/2016 Page 16 of 17 Value [WDV] of the lease rentals capitalized in AY 2010-11 in respect of which DRP for AY 2010-11 directed the AO to allow depreciation. It was a consequential claim based on the outcome on the issue of lease rentals for AY 2010-11. The AO in his draft assessment order dated 30.3.2015 did not disallow the claim of the Assessee for deduction on account of depreciation. On objections by the Assessee before DRP, the DRP directed the AO to give effect to directions of DRP for AY 2010-11 and allow depreciation. The AO in his final assessment order which is subject matter of this appeal disallowed a sum of Rs.1,49,65,386 instead of allowing depreciation on WDV of the sum of Rs.1,64,45,484/- as directed by the DRP. The sum of Rs.1,49,65,386 was arrived at by the AO by reducing a sum of Rs.14,80,094 from the opening WDV of lease rentals of Rs.1,64,45,484/-. The approach of the AO in the final order of assessment is not accordance with law and in compliance with the directions of the DRP. As per directions of DRP, the AO should have allowed deduction on account of depreciation of Rs.14,80,094. We hold and direct accordingly and allow ground B 1 raised by the Assessee. Other grounds of appeal are either consequential or were not argued.
In the result, appeal by the Assessee and revenue are partly allowed.
Pronounced in the open court on this 4th day of September, 2020.