RED HAT INDIA PVT LTD,MUMBAI vs. DY CIT CIRCLE- 15 (3)(1), MUMBAI

payment of royalty and service fee: 1.1 The Ld. AO *along with the Learned Transfer Pricing Officer (‘Ld. TPO’)+ under the directions of Hon’ble DRP erred on facts and in law in making adjustment of INR 469,683,748 based on re-characterization of transaction, ignoring the commercial and business aspect, and 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 Hon’ble Mumbai ITAT’s decision in Appellant’s own case for AY 2012-13 and 2013-14 on the issue; b) disregarding the ‘License and Service’ Agreement justifying the arm’s length nature of transaction of payment of ‘Royalty’ and ‘Service fees’; c) 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; d) 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; e) disregarding the fact that the Appellant acts as a limited risk distributor and earns assured margins on revenue in ‘Subscription segment’; f) disregarding the fact that due withholding taxes were deducted on the service payment made to the AE; and g) Disregarding the remand proceedings directed during DRP proceedings, wherein the benchmarking was conducted based on the TNMM as the most appropriate method. 1.3 The Ld. AO 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. AO 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 29,432,376/- 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 On facts and in law, the Ld. AO erred in confirming the error made by the Ld. TPO in computation of the alleged adjustment for the market support services segment despite being directed by the Hon’ble DRP to verify the same and thereby, violating the provisions of Section 144C(10) of the Act.

1.7 The Ld. AO 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 INR 7,642,971/- 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)

Additions on account of unearned revenue from subscription services of Rs. 21, 74, 74,822/-

2.1. The Ld. AO and Hon'ble DRP erred in not following the binding decision of this Hon'ble Income Tax Appellate Tribunal ('ITAT') vide order dated 10 April 2019 for A.Y. 2012-13 and A.Y. 2013-14 wherein on same set of facts, the Hon'ble ITAT has upheld the revenue recognition policy adopted by the Appellant in relation to revenue from subscription services;

2.2. The Ld. AO and Hon'ble DRP erred on facts and in law in making an addition of Rs. 21,74,74,822/- 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 receipt of advance and is not chargeable to tax in the current year;

2.3. The Ld. AO has erred in observing that till A.Y. 2014-15, the Appellant was following completed service contract method and has changed its revenue recognition policy to percentage completion method for the subject year without taking cognizance of the fact that erstwhile Ld. AO himself, based on the directions of the Hon'ble DRP had corrected this incorrect assertion in the final assessment order for A.Y. 2014-15;

2.4. The Ld. AO 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 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; b) 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; c) erred on facts in holding that performance of the Appellant is over and all the significant risks and rewards of ownership is transferred to the customer once the access code is handed over by the Appellant to the 4

customers, without appreciating the fact that privity of contract is between the Appellant and the customer, the Appellant is duty bound to ensure that services are satisfactorily performed over the duration of the contract; and d) Erred on facts in not appreciating that the Appellant is solely responsible for provision of services during the term of the subscription services agreement. 2.5. 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;

2.6. Without prejudice to the above, the Ld. AO and Hon'ble DRP erred in not granting a corresponding deduction/relief of INR 21,44,30,174/- on the preponement 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: 2.7. The Ld. AO erred in short granting credit of Taxes Deducted at Source to the extent of Rs. 2,31,921/- 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. 45,00,000/- while computing the tax liability for the year;

2.9. The Ld. AO erred on facts and in law in levying excess interest under section 234B of the Act;

2.10. The Ld. AO erred on facts and in law in levying the interest under section 234A and 234C of the Act;

2.11. The Ld. AO erred on facts and in law in initiating penalty proceedings under section 274 read with section 271(1)(c) of the Act.

the case of assessee for A.Y. 2012-13, 2013-14, 2014-15 and 2016-17.

customers in India. In consideration for such services, the assessee compensates Red Hat US with (a) royalty for use of intellectual property (trademark/ trade name); and (b) service fees for provision of support services directly to customers. In addition to the above, the assessee renders sales & marketing and software support service to AEs. The international transactions of the assessee have been benchmarked in the transfer pricing study report as under:

International transaction Transfer pricing policy Methodology Payment of royalty - Use TNMM- Royalty @ 3% of intellectual property • Subscription segment (trademark/ trade name) (comparable engaged in RHIPL pays service fee to trading of software Payment of service fee AE after recovering its products) - Provision of support entire cost along with an • Service segment services from Global assured margin of 1.4% (comparable engaged in support centers to for subscription and providing comparable Appellant's customers 13.5% for services services) segment TNMM - Comparable Provision of software Cost + 15% engaged in rendering support service similar services Provision of sales TNMM - Comparable Cost + 5% &marketing support engaged in rendering service similar services

76,42,971/- c. Adjustment under the software support segment Rs. 2,94,32,376/- and d. Addition on account of unearned revenue Rs. 21,74,74,822/- The additions made by the Ld. TPO/Ld. AO were confirmed by the DRP. The assessee taken each addition/adjustment made by the Ld. AO/TPO in the following paragraphs.

Ground 1.1 - 1.3: Adjustment on account of payment of service fees:-

A.Y. 2012-13 & A.Y. 2013-14 ITA No.1456/Mum/2017, ITA No. 727I/Mum/2017

“28. upon careful consideration, we find that the actual payment for royalty and service 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 have 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 8

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 by 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 of the considered opinion that the transfer pricing adjustment of INR 13, 52, 26,045/- for A.Y. 2012-13 and INR 27, 70, 02,848/- for A.Y. 2013-14 is unjustified and deserves to be deleted. We order accordingly.

A.Y. 2014-15 ITA No. 7210/Mum/2018

“5. As regards, ground No.1-1.3 adjustment relating to international transactions pertaining to payment of royalty and service fee. It is noted that identical issue was decided by this Tribunal in Assessee’s own case for A.Y. 2012-13 and 2013- 14. No distinguishing feature in the facts in the present year was pointed out by the revenue. It is also not the case that Hon’ble jurisdictional High Court has reversed the order of the ITAT. In this view of the matter following the decision of the co-ordinate bench in Assessee’s own case, we set aside the Transfer Pricing Adjustment (TPA), in this regard and direct the same to be deleted.”

Ground 1.4 - 1.5: Adjustment on account of provision of software support services

“64… So we are of the considered view that the assessee is entitled for working capital adjustment. The Ld. TPO is directed to verify the computation furnished by the Assessee and accordingly provide the working capital adjustment to the Assessee in view of the settled principle laid down by the Tribunal, in order to provide level playing field for Assessee as well as comparable company”

Ground 1.6 - 1.7: Adjustment on account of provision of sales and marketing support services.

on identical facts, the Hon'ble Mumbai ITAT has granted the working capital adjustment to the assessee under all 4 segments. The relevant extract is as under:

“64… So we are of the considered view that the assessee is entitled for working capital adjustment. The Ld. TPO is directed to verify the computation furnished by the Assessee and accordingly provide the working capital adjustment to the Assessee in view of the settled principle laid down by the Tribunal, in order to provide level playing field for Assessee as well as comparable company”

“The assessee’s counsel has submitted that one of the comparable selected by TPO i.e., Axis Integrated Systems Limited suffers from several dysfunctionalties which has been reproduced the assessee’s submission herein above. The assessee’s contention is that if the same is removed from list of comparables selected by the TPO, the ALP margin will be appropriate and hence, no adjustment will be required. As noted above, this comparable suffers from following dissimilarities.

We find cogency in the above submissions, which are duly supported by the case 12

laws. Hence, we direct that this comparable should be removed from the final set of comparables. The AO should make computation accordingly.”

Corporate Tax Grounds

Ground 2.1 - 2.6: Adjustment on account of provision of sales and marketing support services

“61. Upon careful consideration we find that assessee has been following consistent system of revenue recognition. The assessee is inter alia engaged in the business of marketing, promotion and sale of 'Red Hat subscriptions' to customers in Indian sub-continent to avail support services that are for the open- source software system during the subscription period ranging from one to seven year, which is established by the special services agreement or contract. As per the consistent policy of revenue recognition, the assessee accounts for the revenue for service which would be performed in future year in its books as unearned revenue. Assessee's claim is that this practice by the assessee in respect of accounting for the sale of subscription is in accordance with Accounting Standard- 9 issued by ICA1. In support of this it is submitted that for rendering of service AS-9 provides that revenue should either be recognized on straight line basis over a period in which services are proposed to be rendered. The Assessing Officer has tinkered with this regularly adopted system on the plea that no further services is required to be performed by the assessee, that there is no significant uncertainty existing regarding amount of consideration that will be derived. The Assessing Officer has also find fault with completed contract method claimed to have been followed by the assessee.

the facts and circumstances elaborately dealt with above, we find due merits of the revenue recognition adopted by the assessee which is duly supported by mandate of AS-9 and other parameters referred above.

“Reading of the accounting standard makes it clear that the revenue is recognized only when the services are actually rendered. If the services are rendered partially, revenue is to be shown proportionate to the degree of completion of the services. This really clinches the issue in favour of the assessee.”

“…What is the relevant yardstick is the time of accrual or arise for the purpose of its

taxation, viz., in order to be chargeable, the income should accrue or arise to the assessee during the previous year. If income has accrued or arisen, even if actual receipt of the amount is not there, it would be chargeable to tax in the said year. Though the amount may be received later in the succeeding year, the income would be said to accrue or arise if there is a debt owed to the assessee by somebody at that moment. From this, it follows that there must be the "right to receive the income on a particular date, so as to bring about a creditor and debtor relationship on the relevant date". The Court further explained that a right to receive a particular sum under the agreement would not be sufficient unless the right accrued by rendering of services and not by promising for services and where the right to receive is interior to rendering of service, the income, therefore, would accrue on rendering of services...”

Ground No. 2.7

Ground No. 2.8 24. The assessee filed its ‘ROI’ on 28.11.2015, claiming an advance tax credit of INR 4,50,00,000/- which has not been granted in the Assessment Order. The assessee had filed an application under section 154 of the Act on 07 January 2020, which is pending disposal. Therefore, the AO is directed to decide this issue on the basis of evidence brought on record by the assessee by providing opportunity of being heard to the assessee. Consequently, the ground No.2.8 is decided for statistical purposes in favour of the assessee.

Ground No. 2.9 25. The assessee has challenged the levying of interest under section 234B of the Act. Since this ground is consequential in nature, the AO is directed to deal with the issue in accordance with the law and ground is allowed for statistical purposes.

Ground No. 2.10 26. The Assessee has challenged the levying of interest under section 234A of the Act. As per the facts mentioned by the assessee, it had filed its return of income ROI on 28.11.2015, which is within the statutory timelines as per section 139(1) of the Act. However, an interest of INR 29, 41,649/- has been charged as per the Assessment Order. The Assessee has also challenged the levying of interest under section 234C of the Act. As per the facts mentioned by the assessee, it had paid the advance tax due on the returned income for A.Y. 2015- 16 within the statutory timelines. However, an interest of INR 25, 25,598/- has been charged as per the Assessment Order. Given the facts, we are of the view

that no interest under Section 234A and 234C of the Act should be levied. The AO is directed to recompute the tax payable by / refund due to the assessee without said interest. Consequently, the ground No. 2.10 is decided for statistical purposes in favour of the assessee.

Ground No. 2.11 27. This ground is premature and consequential in nature, hence need no finding and dismissed.

Order pronounced in the open court on 9th day of September, 2024. Sd/- Sd/- (RAJ KUMAR CHAUHAN) (GAGAN GOYAL) JUDICIAL MEMBER ACCOUNTANT MEMBER Mumbai, दिन ांक/Dated: 09/09/2024 PS

Copy of the Order forwarded to: अपील र्थी/The Appellant , 1. प्रदिव िी/ The Respondent. 2. 3. आयकर आयुक्त CIT दवभ गीय प्रदिदनदि, आय.अपी.अदि., मुबांई/DR, ITAT, Mumbai 4. ग र्ड फ इल/Guard file. 5. BY ORDER, //True Copy// (Asstt. Registrar) ITAT, Mumbai