ITO, BANGALORE vs. M/S EMULEX COMMUNICATIONS PVT. LTD.,, BANGALORE

1.

3. On the facts and in the circumstances of the case, the Hon'ble Dispute Resolution Panel was not justified in excluding INFOSYS Ltd and Tata Elxsi Ltd as a comparable on the basis of decision in a different case when in TP rejection or acceptance of a comparable in a case on the basis of its appropriateness / inappropriateness in some other is not possible.

4. On the facts and in the circumstances of the case, the Hon'ble Dispute Resolution Panel was not justified in giving direction to the TPO to exclude M/s Persistent Systems & Solutions Ltd, M/s Think Soft Global Services Ltd, R.S.Software (India) ltd and Persistent Systems Ltd as a comparable, without considering the discussion made by the TPO in respect of the comparable company which was accepted by the taxpayer during the TP proceedings.

IT(TP)A Nos.230 and 152/Bang/2015 Page 3 of 20 Assessee’s appeal:

1. That the order of the learned Income-tax Officer, Ward 2(1)(4), Bangalore ("Assessing Officer" or "AO") pursuant to the direction of the learned Dispute Resolution Panel (Panel') to the extent prejudicial to the Appellant, is bad in law and liable to the quashed.

2. That the learned AO/learned Panel erred in upholding the learned Transfer Pricing Officer's ("TPO") approach of rejecting the Transfer Pricing ("TP") documentation maintained by the Appellant; 3. That the learned AO/learned Panel erred in upholding the learned TPO's approach of considering certain expenses, which have been disallowed while computing the total income for the purpose of Income-tax, as a part of operating cost base which leads to double taxation 4. That on the facts and circumstances of the case, the learned AO/learned Penal erred in; Upholding the rejection of comparability analysis of the (a) Appellant in the TP documentation and accepting the fresh comparability analysis performed by the learned TPO with application of certain arbitrary/modified filters Arbitrarily arriving at a set of companies as (b) comparable for the services rendered by the Appellant, on rejecting/not considering companies that are otherwise functionally comparable to the Appellant like Persistent Systems and Solutions Ltd., R S Software (India) Ltd., Thinksoft Global Services Ltd., Akshay Software Technologies Ltd., LGS Global Ltd. and Cat Technologies Ltd., and on inclusion of Kals Information Systems Ltd. that otherwise fails the test of comparability. Disregarding application of multiple year/prior year (c) date as used by the Appellant in the TP documentation and holding the current year (i.e. Financial Year 2009-10) data for companies should be used comparability Upholding the learned TPO's approach of using data as at the time of assessment proceedings, instead of that available as on the date of preparing the TP documentation for IT(TP)A Nos.230 and 152/Bang/2015 Page 4 of 20 comparable companies while determining the arm's length price (e) Upholding the TPO's approach of not providing Risk Adjustment and thus ignored the limited risk nature of the services provided by the Appellant and in not providing an appropriate adjustment towards the risk differential. even when full-fledged entrepreneurial companies are selected as comparables.

Net margin on cost earned by the Assessee (as reflected in the TP order): Operating Income Rs.29,54,66,768/- Operating Expenses Rs.26,79,44,050/- —Op. Rs.2,75,22,718/- Operating Profit/Loss(Op. Income Expenses) Operating/Net margin (OP/OC) 10.27%

Comparables selected by TPO and their arithmetic mean: SI NCP NCP Margins No. Margins as as per TPO per TPO Order (%) Comparables Selected by TPO Order (%) (WC - Adj) (WC- Unadj) ICRA Techno Analytics Ltd.(seg) 24.94 31.53 1. Infosys Ltd. 44.98 51.55 2. Kals Information SystemsLtd. 34.41 37.27 3. Larsen &Tubro Infotech Ltd 19.33 26.37 4. Mindtree Ltd. (Seg) 14.83 19.67 5. Persistent Systems and Solutions 13.58 22.06 6. Ltd. 30.35 34.92 Persistent Systems Ltd. 7. 10.29 17.42 8. R S Software (India) Ltd. Sasken Communication 17.36 23.40 9. Technologies Ltd. Tata Elxsi (Seg) 20.93 24.09 10. Thinksoft Global Services Ltd. 17.05 20.88 11. Arithmetical Mean 22.71 28.11

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Computation of arm's length price by TPO and the adjustment made: Arm's length mean margin 22.71% Less: Working capital adjustment (-)5.39% Adjusted mean margin of the comparables 28.1% Operating cost Rs.26,79,44,050/- Arm's Length Price (ALP): 128.1% of Operating Cost Rs.34,32,36,328/- Rs.29,54,66,7686/- Price Received Short fall being adjustment u/s. 92CA Rs.4,77,69, 560/- The aforesaid shortfall, consequent to determination of ALP, was added to the total income of the Assessee in the draft order of assessment passed by the AO.

The DRP directed exclusion of ICRA Techno Analytics Ltd., Infosys (i) Technologies Ltd., Tata Elxsi Ltd. and Persistent Systems Limited.

The DRP did not accept the contention that KALS Information System (ii) Ltd. ought to be excluded;

The DRP directed exclusion of Persistent Systems and Solutions Ltd., (iii) and Thinksoft Global Services Ltd. on the erroneous basis that the Assessee had sought exclusion of the same.

(iv) The DRP suo motto directed exclusion of R S Software (India) Ltd. on the ground that it is predominantly engaged in onsite software development.

IT(TP)A Nos.230 and 152/Bang/2015 Page 7 of 20

(v) The DRP accepted the Assessee's contention that certain expenses which had been disallowed whilst computing the total income for the purposes of income-tax, ought not be treated as part of the operating cost.

(vi) The errors pointed out in computing the working capital adjustment were directed to be rectified.

Sl. Name of the Company No. 1. KALS Information Systems Ltd. 2. Sasken Communication Technologies Ltd. 3. Mindtree Ltd. 4. Larsen & Toubro Infotech Ltd Pursuant to the DRP's directions, the AO passed the final assessment order wherein the TP adjustment stood reworked to Rs. 2,64,41,213/-.

Infosys Technologies Ltd.,  ICRA Techno Analytics Ltd.,  Tata Elxsi Ltd.  Persistent Systems Limited,  Persistent Systems & Solutions Ltd.,  R S Software (India) Ltd. and  Thinksoft Global Services Ltd. 

IT(TP)A Nos.230 and 152/Bang/2015 Page 8 of 20

The AO/TPO erred in considering certain expenses as part of (i) the operating cost whilst computing the margin of the Assessee, despite the DRP's directions to the contrary. (Revised Ground No. 3)

KALS Information Systems Ltd. is not comparable to the (ii) Assessee and ought to be excluded from the list of comparables. (Ground No. 4(b)):

(iii) The DRP erred in suo moto excluding following companies which are comparable to the Assessee and ought to be included in the list of comparable companies (Ground No. 4(b)).

Persistent Systems and Solutions Ltd.: i) ii) R S Software (India) Ltd.; and iii) Thinksoft Global Services Ltd. iv) That LGS Global Limited and Cat Technologies Limited are comparable to the Assessee and ought to be included in the list of comparables (Ground No. 4(b))

“(1) ICRA Techno Analytics Ltd. (seg) 14. At the outset, we note that apart from having the related party revenue at 20.94% of the total revenue, this company was also found to be functionally not comparable with software development services segment of the assessee. The DRP has given its finding at pages 13 to 14 as under:— "Having heard the contention, on perusal of the annual report, it is noticed by us that the segmental information is available for two segments i.e., services and sales. However, it is evident from the annual report that the service segment comprises of software development, software consultancy, engineering services, web development, web hosting, etc. for which no segmental information is available and therefore, the objection of the assessee is found acceptable. Accordingly, Assessing Officer is directed to exclude the above company from the comparables."

15. We find that the facts recorded by the DRP in respect of business activity of this company are not in dispute. Therefore, when this company is engaged in diversified activities of software development and consultancy, engineering services, web development & hosting and substantially diversified itself into domain of business analysis and business process outsourcing, then the same cannot be regarded as functionally comparable with that of the assessee who is rendering software development services to its AE.

IT(TP)A Nos.230 and 152/Bang/2015 Page 10 of 20

18. The DRP accepted the objections of the assessee and by following the decision of the Delhi Benches of the Tribunal in the case of Agnity India Technologies (P.) Ltd. v. ITO [2015] 58 taxmann.com 167/154 ITD 293 (Delhi - Trib.), directed the TPO to exclude this company from the list of comparables.

IT(TP)A Nos.230 and 152/Bang/2015 Page 11 of 20

Amount in Rs. lakhs Year ended March 31, 2010 Year ended March 31, 2009 Software Services 37,736.22 40,531.20 Software products 2,041.00 6,146.43 Other services 372.77 1,297.05 Total revenues 40,150.89 47,974.68

23. Thus, there is no dispute that this company earns revenue from 3 segments. However, the segmental operating margins are not available. Therefore, in the absence of segmental relevant data and particularly operating margins, this composite data cannot be considered as comparable with the assessee for software development services segment. Accordingly, we do not find any error or illegality in the findings of the DRP. (6) Tata Elxsi Ltd.

24. The assessee has raised objections against this company on the ground that the company is functionally different from the assessee. Though the TPO has considered the software development and services segment of this company as comparable to that of assessee, however, the assessee contended that even within the software segment, this company is engaged in diverse activities. The assessee placed reliance on the information in the annual report under the Directors Report and submitted before the DRP that even under the software development services segment, this company is engaged in various diversified activities including product design service, innovation design, engineering service, visual computing labs, etc. The assessee also placed reliance on the decision of Mumbai Bench of the Tribunal in the case of Telcordia Technologies India (P.) Ltd. v. Asstt. CIT [2012] 137 ITD 1/22 taxmann.com 96. 25. The DRP found that this company is not functionally comparable with assessee company as it is engaged in diversified activities even in the software development services. The DRP has followed the decision of the Mumbai Bench of the Tribunal in the case of Telcordia Technologies India (P.) Ltd. (supra). 26. We have heard the ld. DR as well as ld. AR and considered the relevant material on record. We find that this company even in the software development segment is engaged in diversified activities of product design services, innovation design, engineering services, visual computing labs, etc. We further note that in the case of Telcordia

IT(TP)A Nos.230 and 152/Bang/2015 Page 12 of 20 Technologies India (P.) Ltd. (supra), the Mumbai Bench of the Tribunal vide its order dated 11.5.2012 in para 9.7 has held as under:— "7.7 From the facts and material on record and submissions made by the learned AR, it is seen that the Tata Elxsi is engaged in development of niche product and development services which is entirely different from the assessee company. We agree with the contention of the learned AR that the nature of product developed and services provided by this company are different from the assessee as have been narrated in para 6.6 above. Even the segmental details for revenue sales have not been provided by the TPO so as to consider it as a comparable party for comparing the profit ratio from product and services. Thus, on these facts, we are unable to treat this company as fit for comparability analysis for determining the arm's length price for the assessee, hence, should be excluded from the list of comparable parties."

12. In Ground No.7 of its appeal, the revenue has challenged the exclusion of Persistent Systems Ltd. [Persistent Systems' for short], Persistent Systems and Solutions Ltd. ["Persistent Systems and Solutions"]. Thinksoft Global Services Ltd. [-Thinksoft"] and RS Software Ltd. [“RS"]. The Assessee had not objected to the inclusion of Persistent Systems and Solutions, Thinksoft and RS Software Ltd., before the DRP and therefore, to that extent ground no. 7 raised by the Revenue is allowed.

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“(4) Persistent Systems Ltd.

25. The DRP has noted the fact that this company has reported the entire receipt from sales and software services and product. Therefore, no segmental information was found to be available for sale of software services and product. Further, the DRP has noted that as per Note 1 of Schedule 15, this company is predominantly engaged in outsource software development service. Apart from the revenue from software services, it also earns income from licence of products, royalty on sale of products, income from maintenance contract, etc. These facts recorded by the DRP has not been disputed before us.

26. Therefore, when this company is engaged in diversified activities and earning revenue from various activities including licencing of products, royalty on sale of products as well as income from maintenance contract, etc., the same cannot be considered as functionally comparable with the assessee. Further, this company also earns income from outsource product development. In the absence of any segmental data of this company, we do not find any error or illegality in the findings of the DRP that this company cannot be compared with the assessee and the same is directed to be excluded from the set of comparables.”

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“(3) KALS Information Systems Ltd.

22. The DRP has directed the AO to exclude this company from the list of comparables by taking note of the fact that there were inventories in the books of accounts of this company which shows that this company is in the software product business. Further, by following the decision of this Tribunal in the case of Trilogy E-Business Software India (P.) Ltd. v. Dy. CIT [2013] 140 ITD 540/29 taxmann.com 310 (Bang. - Trib.), this company was found to be not comparable with that of the assessee.

the business of software products, the same cannot be compared with a pure software development services provider. Accordingly, we do not find any error or illegality in the impugned findings of the DRP.”

16. Respectfully following the aforesaid decision, we hold that the aforesaid company ought to have been regarded as not comparable company with the Assessee by the DRP and hence, we find merits in the relevant grounds of appeal of the Assessee and allow the same.

In ground No.4b, the assessee has sought inclusion of LGS Global Ltd., 17. and CAT Technologies Ltd., as a comparable company. As far as these 2 companies are concerned, the TPO rejected LGS Global Ltd., as a comparable company on the ground that the exports sales were less than 75% of the total revenue. Before the DRP, the assessee pointed out that the ratio of export sales to total sales was 98.7% and that this company was functionally comparable to SWD services company. The submissions made by the assessee to the DRP in this regard are contained in pages 180 to 182 and 231 to 232 of the assessee’s Paper Book. The DRP did not adjudicate the inclusion of this company. The learned DR, in his submission, pointed out that this company should also be tested on the basis of functional comparability, if the comparability of this company is restored to the TPO for fresh consideration. Similarly, the learned Counsel pointed out that CAT Technologies Ltd., was rejected by the TPO for the reason that the details of related party transactions were not available. The plea of the assessee was that in the Annual Report, there was a column for reporting related party transaction, but no transactions had been reported. It is a plea of the assessee that there were no related party transaction and that is the reason why the Annual Report did not give details of any related party transaction. The submissions made before the TPO were reiterated before the DRP. But the DRP did not adjudicate on the basis of the comparability of this company. The learned

IT(TP)A Nos.230 and 152/Bang/2015 Page 16 of 20 DR pointed out that this company should also be compared on the basis of functional comparability. The learned Counsel for the assessee submitted that the comparability of the aforesaid two companies can be remanded to the TPO for fresh consideration and that the functional comparability of these two companies can also be considered by the TPO.

19. The learned Counsel for the assessee filed before us a letter in which he has sought modification of the ground No.3 in the revised grounds of appeal

which we have extracted in the earlier part of this order. The modified ground is as follows:

3. That the learned AO/TPO erred in including expenses relating to employee stock compensation amounting to Rs.1,71,42,773/- and provision for service tax amounting to Rs. 42,05,352/- in the operating costs while computing the operating margin, despite the DRP's directions holding them to be non-operating in nature.”

IT(TP)A Nos.230 and 152/Bang/2015 Page 17 of 20 costs and therefore they should not be considered as operating expenses while arriving at the operating margin of the assessee. The DRP on such submission, gave the following directions:

“3.11: Computation of operating cost and operating margin: It is submitted that the TPO has excluded employees stock compensation, provision for service tax and foreign exchange loss as non-operating cost, and excluded 'other income' from the operating revenue. Having heard the assessee, we are of the view that foreign exchange gain/loss are operating in nature in case of export business. The Assessing Officer is directed to include the same as cost/income in case of assessee as well as comparables. Other items are extra-ordinory items and hence non-operating in nature. The other income, if not related to business operations, but interest on FDs etc, has rightly been excluded by the TPO from operating revenue. IT is directed accordingly.”

21. In the order giving effect to the directions of the DRP, the TPO did not exclude the aforesaid two items of expenses while computing the operating margin of the assessee. Ground No.3 is raised by the assessee against such action of the TPO.

IT(TP)A Nos.230 and 152/Bang/2015 Page 18 of 20 of determination of operating profit margin of the assessee to the TPO for fresh consideration after analysis of the operating expenditure considered by the assessee while working out its operating profit margins in the TP analysis. We hold and direct accordingly.

23. The TPO is directed to compute the ALP as per the directions contained in this order, after given opportunity of being heard to the assessee. No other arguments were advanced on the transfer pricing adjustment, except the issues dealt with in the earlier paragraphs.

24. The other non transfer pricing issues that arise for consideration in these appeals are ground Nos.2 and 3 raised by the Revenue in its appeal. The Assessee claimed deduction u/s.10A of the Act of a sum of Rs.4,34,89,367/- . The AO computed deduction under Section 10A of the Act, by reducing only from the export turnover: (1) a sum of Rs. 9,89,323/- being communication charges; and (2) a sum of Rs. 27,55.889/- being travel expenditure incurred in foreign currency. In this manner, the AO recomputed the eligible deduction at Rs. 4,29,26,933 /- as opposed to Rs. 4.34,89,367/- claimed by the Assessee. In its objections before the DRP, the Assessee contended that in the first place, the aforesaid expenses should not be reduced from its export turnover while computing the deduction available to it under Section 10A. In the alternative, it contended that if the said expenses were to be reduced from its export turnover, then they should also be reduced from its total turnover inter alia in terms of the decision of the Hon'ble High Court of Karnataka in C/T v. Tata Elxsi Ltd. [2012] 349 ITR 98 (Kar). The DRP allowed the alternate contention and directed the AO to recompute the deduction by reducing the expenses both from the export turnover as well as the total turnover. The Revenue is ground Nos. 2 and 3 of its appeal is challenging the above direction of the DRP.

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Order pronounced in the open court on this 8th day of November, 2019.