MICROCHIP TECHNOLOGY (INDIA) PVT. LTD. vs. ACIT,

Per Shri Vijay Pal Rao, J.M. : This appeal by the assessee is directed against the assessment order dt.12.10.2012 passed under Section 143(3) r.w.s. 144C of the Income Tax Act, 1961 (in short 'the Act') in pursuant to the directions of the Dispute Resolution Panel (in short ‘DRP’) dt.26.06.2012 for the Assessment Year 2008-09.

“ 1. On the facts and circumstances of the case, there is no justification for the Assistant Commissioner of Income Tax, Circle 12(1), Bangalore to :- Hold that the information or data used by the assessee in the computation of the arm’s length price is not reliable or correct, thereby satisfying the pre-conditions for invoking the provisions of section 92C(3) of the Income Tax Act, 1961(Act). Accordingly, he erred in ignoring the arm’s length price computed by the assessee and proceeding to determine arms length price in terms of section 92C(1) and (2) of the Act. The pre-conditions for the Assessing Officer to proceed to determine the arm’s length price in relation to the international transactions of the assessee company with its associated enterprise have not been satisfied.

2. To adopt a flawed one sided turnover filter of eliminating companies with a turnover of Rs.1 crore and below but at the same time including medium, large and very large companies with huge scale and size of operations, while carrying out the comparability analysis. This one sided stand taken by the TPO is not valid and has vitiated the entire TP analysis carried out by him. He ought to have appreciated the contentions of the Company that in like manner of eliminating very small companies as comparable, medium, large and very large companies ought to be eliminated. He ought to have restricted the comparability analysis only to companies whose level of operations/number of employees/turnover is similar to that of the assessee company.

3. To adopt a flawed one sided stand of eliminating companies having diminishing revenues/persistent losses over a period while carrying out the comparability analysis, but at the same time not hesitating to include companies with continuously increasing revenues/growth/abnormally high margins, while carrying out the comparability analysis. This one sided stand by the TPO has vitiated the entire TP analysis. If companies going through a trough or faring badly are excluded, on the very same coin/argument, companies who are riding a wave with increasing revenues and profits ought to be excluded. The TPO ought to have appreciated that the assessee company is a low risk contract service provider. As a low risk contract service provider, its profit margins are likely to remain within a narrow range of variation, not affected materially by companies riding waves or going through troughs. The TPO ought to have appreciated that the operations of the assessee company cannot be equated and compared with companies having continuously increasing revenues / profits. The learned TPO has erred in adopting a flawed

3 IT(T.P) A No.1586/Bang/2012 Microchip Technology (I) Pvt Ltd process in applying filters and determining the arms length price of international transactions. The TPO has erred in considering companies with high operating margins as comparable. It may be due to extremely favorable/special circumstances peculiar to them, without analysing or proving that their business circumstances prevailing during the year under review were same in all material respects with that of the assessee company.

4. To consider companies as comparable even though not comparable to the assessee in respect of functions performed, risks assumed, assets employed, size and scale of operations, number of employees, market reach, market visibility and other relevant factors. He also erred in not making adjustments to the arms length price determined by him to take into differences in risks assumed, functions performed, assets utilized and other relevant factors. He also erred in relying upon replies received under section 133(6) of the Income Tax Act, 1961 without giving an opportunity to the assessee to cross examine the parties involved. The TPO has erred in law in using data, which was not contemporaneous and which were not available in the public domain at the time of conducting the transfer pricing study by the assessee.

5. The final list of comparables adopted by the TPO is vitiated as a result of flawed processes and application of improper filters. As a result of such flawed processes, wrong application of filters and adoption of one sided filters, many incomparable companies like Infosys Technologies Limited, Tata Elexi Limited, Wipro etc have been considered as comparable with the company. These companies are completely different from the assessee company in terms of functions performed, risks assumed, assets employed, size and scale of operation, turnover, number of employees, market reach and other relevant factors. He ought to have accepted the comparables furnished by the Company and accepted the prices by it as the arms length price.

6. The TPO erred in law and on facts in not allowing appropriate adjustments under Rule 10B to account for, inter alia, differences in (a) accounting practices, (b) Depreciation adjustments, (c) marketing expenditure adjustments, (d) research and development expenditure adjustment, (e) risk profile between the Assessee and the comparable companies (f) under utilization of capacity by the Company.

4 IT(T.P) A No.1586/Bang/2012 Microchip Technology (I) Pvt Ltd 7. Differences in accounting practices and rate of depreciation on fixed asses not adjusted by the TPO. a The TPO erred in not appreciating our contentions that the charge for depreciation provided by some of the companies considered as comparable by him was lower than that adopted by the Company (rate of depreciation on computers adopted by certain companies considered as comparable by the TPO is 16.21% whereas the Company adopts a higher depreciation rate of 33.33% on the said assets). He accordingly erred in not increasing the cost base and reducing the operating profit margin of these companies, by bringing the depreciation rate for these companies on par with the Company. b The TPO erred in not appreciating our contentions that some of the companies considered as comparable by him were not providing for accrued gratuity and leave encashment liability in terms of accounting standard 15 issued by the Central Government. He accordingly erred in not increasing the cost base and reducing the operating profit margin of these companies, by bringing their accounting policy for accrued gratuity and leave encashment liability in line with accounting standard 15 issued by the Central Government. c The TPO erred in not considering properly the effect of the Employee stock compensation cost (ESOP). Microchip India has recognized a sum of Rs.114.83 lakhs as employee stock compensation cost. This represents the cost of options provided by its parent company to the employees of Microchip India, computed on the basis of the Black Scholes method and as per generally accepted principles (GAAP) prevailing in the US. Please note that this does not represent cost of ESOPs provided by Microchip India but by its parent company. This expense has been added back while computing total income. Employee stock compensation cost are evaluated differently even by companies recognizing them- some based on Black Scholes method and others based on the intrinsic value method. The costs computed based on the two methods result in vastly different charge to the Profit and Loss Account. A large number of assumptions are made while computing cost based on Black Scholes method like rate of risk free returns, weighted average expected life of options, volatility in the value of shares, expected dividends, expected number of options which will not vest due to attrition etc. These assumptions may be made differently by various companies. In the case of our parent company, the cost of employee stock compensations have been computed

5 IT(T.P) A No.1586/Bang/2012 Microchip Technology (I) Pvt Ltd based on GAAP/ conditions prevalent in the USA, which would necessarily be different from other Indian companies following the Black Scholes method who would compute them based on Indian GAAP/ conditions prevalent in India. In fact the Indian accounting standards prescribed by the Central Government under section 211 (3C) of the Act do not mandate that companies recognize employee stock compensation cost in their financial statements. To eliminate the impact of companies not accruing the cost of the same or adopting differing methods/assumptions by few companies which accrue the same and to make comparison meaningful, the charge for ESOP made by us as well as by any of the companies considered as comparable should be added back and thereafter OP/TC be computed. It will be a travesty of fairness if employee stock compensation costs are disallowed but at the same time considered as cost to determine the arms length price. The learned TPO may please appreciate that chapter X has been founded on the premise of tax evasion and labeled as ‘anti avoidance’ provisions. This cannot be interpreted in a manner where arms length profit margins are applied on expenses which are disallowed while computing total income and that too based on margins of companies who do not accrue cost of such compensations. On eliminating the impact of employee stock compensation costs debited by us, our OP/TC works out as under:- Particulars Amount (Rs.) Total operating expenses debited to Profit and 20,49,64,275 Loss Account Less Exchange fluctuation loss 4,67,491 Employee stock compensation cost 1,14,63,811 Revised TC 19,30,12,973 Revenue 22,88,52,736 Revised OP 3,58,39,763 Revised OP/TC% 18.56%

6 IT(T.P) A No.1586/Bang/2012 Microchip Technology (I) Pvt Ltd 8 Differences in functions performed, risks assumed and assets employed between companies considered as comparable by TPO and the Company The TPO erred in not making adjustments for differences in functions performed, risks assumed and assets employed between companies considered as comparable by him and the Company. He ought to have appreciated our contentions that many of the companies identified by him as comparable were independent software companies with substantial expenditure on sales and marketing, research and development, collection costs as against a captive software development company like ours, which has no such costs. Accordingly, he ought to have made appropriate adjustments for higher sales and marketing, entrepreneurial, technology, risk or faulty work, contractual obligations, collection risks etc faced by companies considered as comparable by TPO as compared to the Company, which is a low 4risk contract software developer catering only to its parent company. He ought to have appreciated that the functions performed by the company were lower in he value chain vis a vis companies considered as comparable by him, who perform functions higher up the value chain as compared to the company.

9. No adjustment made for lower capacity utilization by the Company The TPO erred in not making adjustments for lower capacity utilization during the year ended March 31, 2008 of 28.84%. He ought to have excluded costs attributable to under utilization of capacity (rent, building maintenance, depreciation on fixed assets) estimated at Rs.5,839,018, wile determining the total operating cost under the transaction net margin method while computing the arms length price.

10. Without prejudice to the foregoing contentions, the TPO erred in not talking cognizance of the fact that the average hourly offshore billing rate of the company compared favourably with other software companies after adjusting for differences in functions performed, risks assumed and assets employed and that the arms length test was satisfied by the ‘Comparable uncontrolled price method’.

11. The TPO erred in not allowing necessary deduction of 5% in terms of proviso to section 92C(2) of the Act. B. DEDUCTION UNDER SECTION 10A 1. On the facts and circumstances of the case, there is no justification for the Assessing 7 IT(T.P) A No.1586/Bang/2012 Microchip Technology (I) Pvt Ltd Officer to compute the deduction under section 10A in the manner laid down in annexure to the assessment order. The total turnover adopted by the Assessing Officer is the total turnover of the Company and not the turnover of the software service undertaking, there4by including turnover of a non-exempt undertaking of Rs.6,15,55,794/-. He is also erred in adopting the entire communication link costs of Rs.47,20,847/- incurred in foreign currency and foreign travel expenses of Rs.1,28,32,732/- as expenses incurred attributable to delivery of computer software outside India. A major part of the foreign travel expenses are not related to delivery to computer software outside India. He also erred in eliminating communication and travel expenses from the export turnover without making similar adjustments to the total turnover of the undertaking. The computation of deduction under section 10A is not in accordance with law.

D. The Assessee submits that based on the facts and circumstances of the case, there is no basis for the Assessing officer to propose to initiate proceedings under section 271(1) (c) of the Act. Your appellant seeks leave to add to, to amend any of the foregoing grounds as and when considered necessary / at the time of hearing. “

The assessee's turnover of international transactions is Rs.22.88 Crores.

Therefore the first issue raised is regarding the applying of proper filter of turnover. Both the parties have agreed in principle that 10 times of the assessee’s turnover on both sides shall be applied as a filter for selecting the comparable companies. The second aspect which is to be considered in this appeal is regarding Related Party Transaction (RPT) filter. The TPO applied 25% RPT. We find that neither the TPO nor the assessee has found any difficulty in 9 IT(T.P) A No.1586/Bang/2012 Microchip Technology (I) Pvt Ltd selection of comparable companies. The TPO has selected as many as 20 companies in the final set of comparables. Therefore this is a normal case of availability of comparables. Accordingly, in view of the consistent view taken by this Tribunal that in the normal circumstances, the RPT tolerance range shall not exceed 15%.

Needless to say the assessee be given a proper opportunity of hearing raising the objections on the functional comparability of the company.

10 IT(T.P) A No.1586/Bang/2012 Microchip Technology (I) Pvt Ltd The Assessing Officer while computing deduction under Section 10A took the total turnover of the assessee at entity level instead of the turnover of Export Oriented Undertaking (EOU). The Assessing Officer took the total turnover of the assessee at Rs.29.04 Crores whereas the turnover of the EOU undertaking is Rs.22.88 Crores. Therefore we find that the Assessing Officer has not taken the total turnover of the EOU undertaking. In view of the above facts and circumstances of the case, we direct the Assessing Officer to consider the total turnover of the EOU for the purpose of computing the deduction under Section 10A of the Act.

“ ADDITIONAL GROUNDS OF APPEAL 2.0 On the facts and circumstances of the case, there is no justification for the Assessing Officer for not allowing necessary deduction for a sum of Rs.1,55,22,724/- (division eligible for relief under section10A – Rs.1,14,63,811/- and division not eligible for relief under section 10A – Rs.40,58,913) representing cost of Stock Options and RSUs granted to the employees of the company by MTI the holding company or in the alternative for a sum of Rs.5,39,450/- when amounts were paid by the company to its parent company on vesting of the relevant Stock Options / RSUs. 3.0 The Assessing Officer erred in not following the ratio of the decision of the Hon'ble ITAT, Special Bench in the case of Biocon Limited 115 TTJ 649 and the Bangalore Bench of the Hon'ble ITAT in case of Novo Nordisk India (Pvt.) Ltd. Vs. DCIT 12(2), Bangalore. The Assessing Officer ought to have appreciated that the said amount is in the nature of employee compensation expenditure, is not a capital expenditure and has been expended wholly for the business of the company.

11 IT(T.P) A No.1586/Bang/2012 Microchip Technology (I) Pvt Ltd In view of the above and other grounds to be adduced at the time of hearing, the appellant prays that the additional grounds may be admitted in the interest of fairness and justice and disposed of on merits.”

12 IT(T.P) A No.1586/Bang/2012 Microchip Technology (I) Pvt Ltd 13. We have considered the rival submissions as well as the relevant material on record. There is no dispute that the claim made by the assessee in the additional ground was not raised either before the Assessing Officer or before the DRP. Therefore this is fresh plea raised by the assessee at this stage. So far as the legality of the issue is concerned, there is no bar for raising this legal issue at this level which is also covered by the decision of the Special Bench in the case of Biocon Ltd. Vs. DCIT (supra). However this issue also involves verification of the various facts and computation of deduction. Therefore this is an issue involves mixed question of law and facts and not a pure question of law. Accordingly, in the facts and circumstances of the case and in the interest of justice, we set aside this issue to the record of the Assessing Officer to properly examine the record on the point where all the relevant facts are already brought on record by the assessee or not and further whether the apportionment of the deduction in respect of cost of stock option and RSU have already been done at the time of following the return of income or this apportionment has been done by the Assessing Officer at the time of framing the assessment. Hence the Assessing Officer has to consider and adjudicate

13 IT(T.P) A No.1586/Bang/2012 Microchip Technology (I) Pvt Ltd this issue of all aspects. The issue is kept open for adjudication of Assessing Officer.