ITO, NEW DELHI vs. M/S. H & S SOFTWARE DEVELOPMENT & KNOWLEDGE MANAGEMENT, GURGAON

This is an appeal by the department against the order dated 27.11.2014 passed by the AO u/s 143(3) r.w.s. 144C of the Income Tax Act, 1961 (hereinafter referred to as the Act).

Whether the observations of Hon’ble DRP is right in directing the TPO to give working capital adjustment [using OCED methodology given in Annexure to chapter – 3 and applying SBI Prime Lending Rate (as on 30th June of the relevant financial year) as the interest rate] against the TPO order dated 16.01.2014 passed u/s 92CA(3) for A.Y. 2010-11.

From the above grounds, it is gathered that only grievance of the department relates to the direction of the ld. DRP to the TPO to give working capital adjustment.

Facts related to this issue in brief are that the assessee filed its return of income on 28.09.2010 declaring income at Rs.19,32,894/-. Later on, the case was selected for scrutiny. The assessee filed the Transfer Pricing Report in Form 3CEB. The AO by considering the international transactions of the assessee with associated enterprises (AEs) totaling to Rs.14,71,48,937/-, referred the matter to the Transfer Pricing Officer for determining the arm’s length price of the international transactions as per the provisions of Section 92CA of the Act. The assessee in the TP study selected H&S Software Development & Knowledge Management Centre Pvt. Ltd. TNMM as the most appropriate method to benchmark the international transaction and had selected 7 comparables, whose average margin was 13.62% as against the assessee’s margin of 13.81%. Since the assessee’s margin was within the range of ±5%, therefore, it was contended that this transaction was at arm’s length price. The TPO, however, did not agree with the various filters used by the assessee in its TP study and by using certain more filters, he rejected 6 comparables from assessee’s set and selected 11 new comparables. He, thus, selected a set of 12 comparables (1 from assessee’s set and 11 new comparables) whose average margin was 33.14% as against assessee’s margin was 13.81% and proposed the adjustment of Rs.2,40,44,219/-. Subsequently, the AO passed the draft assessment order to assess the assessee at an income of Rs.2,62,86,830/-. Against the draft assessment order, the assessee filed the objections before the ld. DRP who issued certain directions, the TPO thereafter passed the order u/s 92CA of the Act and worked out the adjustment on account of arm’s length price at Rs.2,40,44,219/-.

One of the issue agitated by the assessee before the ld. DRP was relating to the denial of adjustment on account of H&S Software Development & Knowledge Management Centre Pvt. Ltd. working capital while working out the average margins of the comparable. The gist of the submissions by the assessee before the ld. DRP was as under: • No adjustment have been undertaken by the ld. AO to the margins of the comparables selected by the TPO to account for differences in the working capital and risk profile of the companies and the taxpayer. • In this regard, it is submitted that the Indian transfer pricing regulations Rule 10B(3) read with Rule 10B(1)(e) recognize that appropriate adjustments should be made to eliminate material effect of differences between the international transactions and the comparables transactions to establish comparability.”

The ld. DRP after considering the submissions of the assessee directed the TPO to give working capital adjustment using the OECD methodology and to apply SBI Prime Lending rate as the interest rate. The relevant findings have been given by the ld. DRP in paras 8.2 to 8.2.4 which are reproduced verbatim as under: “8.2 This DRP has considered the taxpayer's contention with regard to the adjustments on account of working capital and also the arguments of the TPO. Working capital is measured by trade receivables/debtors, trade payables/creditors and inventories. Interest cost will be high if the trade H&S Software Development & Knowledge Management Centre Pvt. Ltd. receivable/debtors time cycle is large. Interest cost will be low if the company can pay its liabilities alter a larger period of gap then pay it in a shorter period. Holding of inventory has also interest costs. If inventory turnover is for a shorter period, interest cost will be lower. Thus all parameters namely trade debtors, trade creditors and inventories do affect the overall results of the company. In order to cover the interest cost, the margin may seem to be high in absolute term, but when Interest cost is accounted for, the margin changes its luster Therefore, working capital requirements do affect the margins or prices, costs or profits because this is a implicit cost which is recovered/recoverable from the customers. Therefore, this DRP is of the opinion that in view of the Rule 10B(3) and in order, to improve the comparability, in the facts of the present case, while comparing the margins of tested party with that of the comparables, adjustment be made for working capital for which the reliable data is to be provided by the taxpayer. 8.2.2 The TPO has stated that the taxpayer has not demonstrated that there is a difference in the levels of working capital employed by it vis-a-vis the comparables which affect prices and consequently profits. With regard to this objection, as discussed above that holding of inventories, trade debtor/ creditors, trade receivable/payable has always an H&S Software Development & Knowledge Management Centre Pvt. Ltd. interest cost. Therefore there is definitely a connection in the level of working capital and the price at which one is willing to offer its services/goods. Hence, this ground of rejecting taxpayer's claim of working capital adjustment by the TPO is not tenable. 8.2.3 TPO has also referred to OECD guidelines which state that only reasonably accurate adjustments can be made, In this respect, TPO has raised the issue of unreliable data and has pointed out that monthly data of comparables as well as segmental data is not available for making reasonably accurate working capital adjustment. Monthly data in respect of comparables would not be available. This DRP is of the view, that the average of opening and closing balance of the inventories and of trade receivable/payable, trade debtors/creditors, for the relevant year may be adopted which may broadly give the representative level of working capital over the year. Even if there is some difference with respect to the representative level, it will not affect the comparability as the same method will be applied to all cases. Same is the case with segmental data. 8.2.4 Hence, from the above discussion the TPO is directed to give working capital adjustment using the OECD methodology given at it in Annex to Chapter III and apply SBI Prime Lending rate (as H&S Software Development & Knowledge Management Centre Pvt. Ltd. on 30th June of the relevant financial year) as the interest rate. It has boon a general matter of observation by this Panel that in many of the cases the taxpayers do not strictly follow the guidelines provided by OECD for the computation of working capital adjustment. For example in some of the cases it has been observed that instead of taking into account only trade creditors the taxpayers also take into account credits received from various group concerns or loans etc Similarly, creditors on account of capital items are also observed to be included in many cases. Since, this practice is not in accordance with the Guidelines, the TPO and the taxpayer are directed to take following into consideration while working out the working capital adjustment:- a) compute the average of opening and closing balances of inventories, trade debtors/receivables, trade creditors/payables of both the tested party and the comparables, on revenue account only. b) work out the net working capital ratio (in percentage) after dividing the net working capital by operating cost/sales or such denominator (as is used in the PLI) both for the tested party and the comparables. c) determine the difference between the tested party's ratio with that of each comparables. d) thereafter multiply the above difference by interest rate i.e. SB! Prime Lending Rate as on 30th June of the relevant financial year.

Now the department is in appeal. The ld. CIT DR strongly supported the orders of the AO/TPO. It was further submitted that the assessee did not provide the relevant data to the TPO. A reference was made to para 9 at page no. 43 of the TPO’s order wherein the TPO has mentioned that the assessee has not demonstrated that there was difference in the levels of the working capital employed by it vis-à-vis the comparables and that the claim of working capital adjustment was not a matter of right.

In his rival submissions, the ld. Counsel for the assessee submitted that complete data was furnished before the TPO and the ld. DRP. A reference was made to page nos. 218 to 220 of the assessee’s paper book. It was further submitted that the department has accepted the working capital adjustment in all other years except the year under consideration, therefore, the ld. DRP was justified in directing the TPO to give the working capital adjustment. Reliance was placed on the decision of the ITAT Pune H&S Software Development & Knowledge Management Centre Pvt. Ltd. Bench ‘B’, Pune in the case of Demag Cranes & Components (India) Pvt. Ltd. Vs DCIT, Circle-1(2), Pune.

We have considered the submissions of both the parties and perused the material available on the record. In the present case, it appears that the assessee furnished the calculation for adjustment on account of working capital before the ld. DRP who after considering the submissions of the assessee and the guidelines provided by OECD for the computation of working capital adjustment directed the TPO to do needful. As regards to the objection of the TPO that the assessee had not demonstrated that there was a difference in the levels of working capital employed by it vis-à-vis the comparables which affected price and consequently profit, the ld. DRP categorically stated that holding of inventories, trade debtor/ creditors, trade receivable/payable has always an interest cost. Therefore there is definitely a connection in the level of working capital and the price at which one is willing to offer its services/goods. The ld. DRP held that the rejection of the assessee’s claim of working capital adjustment by the TPO was not tenable.

As regards to the observation of the TPO that monthly data of comparables as well as segmental data was not available for making reasonably accurate working adjustment. The ld. DRP directed the TPO that average of opening and closing balance of the inventories and the trade receivable/payable, trade debtors/creditors for the relevant year may be adopted which may broadly give the representative level of working capital over the year. In our opinion, the ld. DRP rightly directed the TPO to compute the working capital adjustment by using the OECD methodology. We do not see any valid ground to interfere with the findings given by the ld. DRP. Accordingly, we do not see any merit in this appeal of the department.

In the result, the appeal of the department is dismissed. (Order Pronounced in the Court on 04/01/2018)