CIENA INDIA PVT. LTD.,GURGAON vs. DCIT, NEW DELHI

Date of Hearing : 28.02.2017 Date of Order : 22.03.2017

O R D E R

PER KULDIP SINGH, JUDICIAL MEMBER :

“1. That on the facts and in the circumstances of the case and in law, the order passed by the Ld. Assessing Officer ('AO') is bad in law.

2. The Ld. AO/ Ld. Transfer Pricing Officer ('TPO') erred on facts and in law in making an adjustment to the arm's length price of the Appellant's international transactions which resulted in the enhancement of returned Income of the Appellant by INR 57,85,27,473.

3. That the reference made by the Ld. AO suffers from jurisdictional error as the Ld. AO has not recorded any reasons in the assessment order based on which he reached the conclusion that it was ‘expedient and necessary' to refer the matter to the Ld. TPO for computation of the arm's length price, as is required under section 92CA(1) of the Income-tax Act, 1961 ('the Act').

4. The Ld. AO/Ld. TPO/ Ld. Dispute Resolution Panel ('DRP') erred on facts and in law in making an upward adjustment of the arm's length price of the Appellant's international transaction in relation to provision of captive software development services by:

4.1. Not appreciating that the Appellant is entitled to deduction under section 10A of the Act, with respect to the provision of services and therefore, there is no incentive on the part of the Appellant to shift profits to any other jurisdiction;

4.2 Rejecting the comparable companies selected by the Appellant in its Transfer Pricing documentation;

4.3. Accepting companies, which are not comparable to the Appellant in terms of functions, assets and risks;

4.4 Not granting an economic adjustment for the risk mitigated environment in which the Appellant operates.

5. The Ld. AO/Ld. TPO/ Ld. DRP erred on facts and in law in making an upward adjustment of the arm's length price of the Appellant's international transaction in relation to provision of captive marketing support services by:

5.1 Rejecting the comparable companies selected by the Appellant in its Transfer Pricing documentation;

5.2. Accepting companies, which are not comparable to the Appellant in terms of functions, assets and risks;

5.3. Erroneously ignoring comparable companies, obtained by way of a fresh search, provided by the Appellant as a response to the show cause notice; and 5.4 Not granting an economic adjustment for the risk mitigated environment in which the Appellant operates.

6. The Ld. AO/Ld. TPO/ Ld. DRP erred on facts and in law in determining the arm's length price of import of capital equipment by the Appellant from its Associated Enterprises ('AEs') at NIL by:

6.1. Not appreciating that the international transaction of import of capital equipment being inextricably linked with the primary activity of captive software development services should be benchmarked by using Transactional Net Margin Method on an aggregate basis;

6.2. Not appreciating that the Appellant is a cost plus entity and the depreciation of INR 8,64,69,321 (as per the Companies Act, 1956) on such capital equipment had only increased the cost base resulting into more taxable income j tax in India; 6.3. Not appreciating that such assets will be depreciated over a period of time, and the Appellant would be offering more income than the cost of such/assets over such period in totality

6.4. Not appreciating the fact that the import price of these capital equipment have been reviewed by the Custom Authorities at the time of import and necessary Custom duties have been paid wherever required;

6.5. Not appreciating that the used capital equipment were imported at fair market values determined by Chartered Engineers (being third party experts);

6.6. Disregarding the fresh evidences submitted by the Appellant to the Ld. DRP which supports the without prejudice contention of the Appellant, for application of Comparable Uncontrolled Price Method as the most appropriate method (purported to be applied by the Ld. TPO). These fresh evidences were in the form of copy of invoices on sample basis of similar capital equipment sold by the AEs to third parties.

7. Without prejudice to above, the Ld. AO erred on the facts and in law by following the order of Ld. TPO and enhancing the income of the Appellant by the amount capitalized in respect of such capital equipment amounting to INR 57,30,63,268, without appreciating the fact that the Appellant has claimed the amount of depreciation of only INR 25,57,43,681 (as per the Act read with the Income-tax Rules, 1962) thereon.

8. That on the facts and circumstances of the case and in law, the Ld. AO has erred in initiating penalty proceedings under section 274 read with section 271(1)(c) of the Act for furnishing inaccurate particulars without recording any adequate satisfaction for such initiation.

9. That the Ld. AO erred in facts and in law in charging and computing interest under section 234B, 234C and 234D of the Act.”

2. Briefly stated the facts of this case are : the assessee company is a wholly owned subsidiary of Ciena Corporation, USA, and engaged in provision of software development and marketing software services to its overseas group company. Assessee is a 100% EOU under the Software Technology Park Scheme incorporated on June 27, 2005 and commenced its operation w.e.f.

April 10, 2006. Assessee company is remunerated on cost plus basis for providing services, namely, contractual software development and marketing software services. During the year under assessment, the assessee entered into the international transactions detailed in Form 3CEB as under :-

Sr.No. Nature of Transaction Arm’s length price as per taxpayer (i) Software service Rs.1,51,39,91,308 (ii) Market Support service Rs. 4,67,48,181 (iii) Purchase of capital goods Rs. 57,30,63,268

Then, the TPO made addition of 11 new comparable companies on the basis of examination of accept/reject matrix of assessee company and determined the arm’s length margin at 30.52% vis-à- vis OP/OC 13.01% earned by the assessee and thereby made an adjustment of Rs.23,45,63,894/-.

GROUNDS NO.1 & 2 10. Grounds Nos.1 & 2 are general in nature, hence need no specific adjudication.

GROUNDS NO.3, 4.1, 4.2, 5.1 & 5.4 11. Ld. AR for the assessee has not pressed the aforesaid grounds, hence determined against the assessee.

GROUNDS NO.4 & 4.3 12. The assessee company challenged the upward adjustment of arm’s length price of assessee’s international transaction qua provision of software development services made by the AO/TPO/DRP by accepting incomparable companies. The final set of comparables considered by the TPO for benchmarking the international transactions are tabulated as under :-

Sr.No. Name of the company OP/OC 1. Akshay Software Technologies Ltd. -1.07% 2. E-Infochips Bangalore Ltd. 71.38% 3. Infinite Data System Private Ltd. 88.25% 4. Infosys Limited 45.47% 5. Larsen & Tourbo Infotech Ltd. 19.06% 6. LGS Global Limited 12.78% 7. Mindtree Ltd. (Segment) 13.92% 8. Persistent Systems Limited 29.02% 9. Quintegra Solutions Ltd. 1.46% 10. R S Software (India) Ltd. 10.18% 11. Sasken Communication 17.54% Technologies Ltd.

COMPARABLE COMPANIES SOUGHT TO BE EXCLUDED BY THE ASSESSEE COMPANY FROM THE FINAL SET OF COMPARABLES FOR BENCHMARKING THE INTERNATIONAL TRANSACTIONS QUA SOFTWARE DEVELOPMENT SERVICES E-INFOCHIPS BANGALORE LIMITED 14. Assessee company challenged the inclusion of this company as comparable on ground of functional dissimilarity; segmental information not available; fluctuating trend; abnormal super normal profit and significant intangible and relied upon decision rendered by coordinate Bench of ITAT, Delhi in case of Headstrong Services (India) Pvt. Ltd. in order dated 18.03.2016.

16. First of all, ld. AR for the assessee opposed the inclusion of this company as comparable on ground of functional dissimilarity vis-à-vis assessee company that this comparable company is engaged in software services as well as ITE services; that this company is giving diversified services including software, firmware, hardware, field programmable gate array (FPGA), application specific integrated circuit (ASIC) and QA & testing in highly specialized and critical industry verticals like aero space, security and surveillance, medical devices and others, hence the requirements and dynamics of this company are very complex and are not comparable to the assessee company. Ld. AR also contended that E-Infochips Bangalore Ltd. engaged in product development and cannot be considered as a comparable vis-à-vis assessee company and relied upon Fiserv India Private Limited in order dated 26.06.2015, available at pages 29 to 46 of the compilation of case laws.

“12.2. After considering the rival submission and perused the relevant material on record, we find from the Annual Report of this company available on page 352 of the paper book that its P & L Account shows `Income from software services’ as one unit at Rs.43,04,66,481/-. Schedules 7 gives break up of this income with “Income from Software Services” at Rs. 37.13 crore and “Consultancy Charges” at Rs. 5.90 crore. Segmental information of this company is available on page 66 of its Annual Report which states that : “The Company is primarily engaged in Software Development and I.T. enabled services which is considered the only reportable business segment”. This indicates that the revenue from Software Development and ITES has been clubbed by this company which also includes consultancy charges. No doubt Consultancy charges in relation to Software Development are part of overall Software Development, but the inclusion of ITES in the overall segment frustrates the comparability. We are currently dealing with the international transaction of `Provision of Software Development services’ and the international transaction of ITES is separate which has also been benchmarked distinctly. In our considered opinion, e-Infochips Bangalore Ltd. having a pool of both software developments and ITES segments into the overall segment designated as `Software development’, cannot be considered as comparable on entity level with the international transaction of `Software development’ of the assessee. We, therefore, order for the exclusion of this company from the list of comparables.”

INFOSYS LIMITED 21. Assessee sought exclusion of this company as a comparable by raising objections inter alia that this company has its own brand value; that it is having turnover of 135 times of the assessee; that there are extra ordinary events affecting its profitability and incorrect margin calculations. The ld. AR for the assessee contended that in assessee’s own case, this comparable was excluded by the Tribunal by relying upon the judgment of Hon’ble jurisdictional High Court in CIT vs. Agnity India Technologies Pvt. Ltd. in ITA 1204 / 2011 decided on 10.07.2013, order available at pages 126 to 131 of the compilation of case laws.

TPO also rejected the arguments addressed by the assessee that this comparable company has spent Rs.78,42,59,246/- on selling and marketing expenses on the ground that as per Schedule 12 of the P&L account, it has spent only Rs.1,33,15,247/- on marketing and other related services. TPO also rejected the assessee’s contention that the comparable company is possessing huge brand value sufficient to influence the pricing policy of the company thereby directly impacting margins of the company on the ground that the company has spent a meager amount of 0.06% of the revenues and could not have generated brand value with this amount and retained this company as a suitable comparable.

PERSISTENT SYSTEMS LIMITED

No doubt, the comparable company is engaged in software development services but it is also a software product company and had entered on entity level it had impacted the total profit of the company.

THIRDWARE SOLUTIONS 29. Assessee sought the exclusion of this company as a comparable on the grounds inter alia that it is functionally dissimilar being engaged in product development qua which segmental accounts are not available; that it has abnormal/super normal profit and that it is indicated in diversified services like sale of licences, software services, export and revenue from subscription, development of software product qua which no segmental disclosure have been made by the company in its audited financial statement and relied upon in the case of Fiserv India Private Limited (supra).

“10.2. We have heard the rival submissions the perused the relevant material on record. It can be observed from the TPO’s order itself that the facts and circumstances of Wipro Ltd., are somewhat similar to Infosys Technologies Ltd., inasmuch as he has proceeded to reject the assessee’s objections by relying on the reasoning given by him for the inclusion of Infosys Ltd. It is further observed that Wipro Limited (Seg.) was considered as comparable by the TPO in the case of Toluna India (supra) and Lear Automotive (supra). The Tribunal, in both the cases, has held Wipro Ltd. (Seg.) as not comparable. This company is also operating as a full-fledged risk taking entity; engaged in providing technology infrastructure services, testing services, package implementation having more than 82,000 employees. It has its own R&D centre. It incurred around 11% of net sales as expenditure on research and development. None of the above factors match with the assessee company. Respectfully following the above precedents, we hold that this company is not comparable.

10.3. There is another reason for holding this company as incomparable. It can be seen that there was a merger of Wipro Infrastructure Engineering Ltd., Wipro Healthcare IT Ltd., Quantech Global Services Ltd., with this company during the year in question. This merger was approved by the Hon’ble Karnataka High Court and the Hon’ble AP High Court during the financial year 2007-08. The Mumbai Bench of the Tribunal in Petro Arandite (P) Ltd. Vs. DCIT (2013) 154 TTJ (Mum) 176 has held that a company cannot be considered as comparable because of financial results distorted due to mergers and demergers, etc. Similar view has been taken by the Delhi Bench of the Tribunal in the case of Toluna India Pvt. Ltd. (supra). As there were amalgamations in Wipro Ltd. during the financial year in question, this fact also makes it incomparable with the assessee company. In view of the foregoing reasons, we direct to exclude Wipro Limited (Seg.) from the list of comparables.”

ADDITIONAL GROUND NO.4.5 36. The assessee company by raising additional ground no.4.5 sought to consider the correct margin of comparable companies specifically Quintegra Solutions Limited. Since the additional ground raised by the assessee company is necessary to adjudicate the controversy at hand, the additional ground is allowed to be raised.

For facility of reference, a margin computation of the final comparable qua Quintegra Solutions Limited (supra) is reproduced as under :-

Income 373,847,298 Add : Misc. Income 57,538 Total Operating Income 373,904,836

Personnel Expenses 274,051,686 Admn. Expenses 62,973,949 Selling & Marketing Expenses 9,930,847 Depreciation 63,206,615 Total Expenses 410,163,097 Less : Non-operating Expenses Forex Liss 2,636,924 Total Operating Expenses 407,526,173

COMPANIES SOUGHT TO BE EXCLUDED AS COMPARABLES FROM THE FINAL SET OF COMPARABLES FOR BENCHMARKING THE ASSESSEE’S INTERNATIONAL TRANSACTION QUA MARKETING SUPPORT SERVICES APTICO LIMITED

HCCA BUSINESS SERVICES PVT. LTD. 41. Assessee sought to exclude this company from the list of comparable for benchmarking the international transaction on the grounds inter alia that this is functionally dissimilar being engaged in providing human resources operations and administrative services; it is providing pay roll processing and compensation structuring; management and labour HR related services and reimbursement processes and accounting services.

TSR DARASHAW LIMITED 44. Assessee sought to exclude this company from the final set of comparables on the grounds inter alia that on ground of functional dissimilarity that this company is into share registry, transfer services, depository services, record management share register services and corporate fixed deposit management, which are not identical to the marketing support services being rendered by the assessee and relied upon Trend Micro India Private Ltd. vs. DCIT in order dated 20.11.2015, available at pages 35 to 59 of the compilation of case laws, and LG Chemical India Pvt. Ltd. (supra), TPO again by overruling the objections raised by the assessee company retained this company as a comparable.

“9.2. Having heard the rival submissions and perused the relevant material on record, we find that this company is a broking and investment banking house with its three segments, namely, Registrar and transfer agent activity (R&T); Records management activity (Records); and Payroll and trust fund activity (Payroll). Under the Registrar and Transfer Agent activity, this company undertakes registrar and transfer agent activity functions for Equity and preference shares, debenture instruments and bonds, commercial paper and private placements. It also undertakes transfer processing, customer/query handling and correspondence, split/consolidation/renewal of certificates, processing and distribution of interest/dividend warrants, payments by physical warrants/through ECS/Direct Credit. Under Records Management Activity, this company undertakes storage, retention & retrieval of physical and/or electronic records. Under Payroll and Trust Fund Activity, this company handles the activities normally handled by “Payroll and Retirement Funds” section in any organization, including interface with regulatory authorities. When we compare all the three broader activities undertaken by this company, namely, R&T, Records and Payroll, with the overall pre and post sale services rendered by the assessee to its AE, on a cost plus basis, we find that there is a huge functional disparity between the two. That apart, the consideration of this company on an entity level by the TPO has rendered the entire exercise of comparison meaningless. Finding striking dissimilarities between this company and the assessee, we order to exclude this company from the final set of comparables.”

CYBER MEDIA INDIA ONLINE LTD. 47. Assessee sought to exclude this company as comparable for benchmarking the international transactions qua marketing support services on the grounds inter alia that this company is functionally incomparable; this company is providing high end services entailing higher risk and is having significant intangibles i.e. trademark and websites contributing up to 14.55% of its total net block.

However, perusal of page 3558 of the annual report of comparable company shows that the proposed amalgamation has not yet taken effect but, at the same time, we are of the considered view that even proposed amalgamation has impacted the business of the company due to which OP/OC of the comparable company has shoot up from 8.14% in FY 2008-09 to 43.10% in FY 2009-10 which is certainly an extra ordinary event and reason or extra ordinary profitability of the comparable company cannot be attributed to the normal business circumstances.

COMPARABLE COMPANY SOUGHT TO BE INCLUDED BY THE ASSESSEE COMPANY FOR BENCHMARKING INTERNATIONAL TRANSACTNION QUA MARKETING SUPPORT SERVICES

GROUNDS NO.6, 6.1, 6.2, 6.3, 6.4, 6.5 & 6.6

Particulars Total amount As per As per capitalized for Companies Income Tax import of capital Act Rules equipment New equipment 32,23,16,507 5,09,04,398 14,57,25,592 Used equipment 25,41,03,286 3,55,64,922 11,00,18,090 Total 57,64,19,793 8,64,69,321 25,57,43,681

For facility of reference, operative part of the order rendered by the coordinate Bench in assessee’s own case for AY 2009-10 is reproduced as under :-

“15.2. We have heard the rival submissions and perused the relevant material on record. It is noticed that the assessee purchased certain fixed assets from its AE with the declared value of Rs.33.50 crore. In our considered opinion the assessee rightly reported Purchase of fixed assets with the transacted value as an international transaction, since the same is covered within the definition given in sub-section (1) of section 92B, which provides that "international transaction" means 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 ..............’. Section 92(1) stipulates that: ` Any income arising from an international transaction shall be computed having regard to the arm's length price’. The manner of computation of arm's length price is set out in section 92C. Sub-section (1) provides that the arm's length price in relation to an international transaction shall be determined by any of the methods given in the provision, being the most appropriate method, having regard to the nature of transaction or class of transaction etc. Amongst others, there is Comparable uncontrolled price (CUP) method and TNMM. The primary onus of proving that the international transaction is at ALP, is always on the assessee.

15.3. Reverting to the facts of the instant case, we find that the assessee applied TNMM as the most appropriate method for showing that this international transaction was at ALP. The TPO held that the correct method to be applied was CUP and as such the assessee was called upon to give uncontrolled comparable instances of the purchase of similar assets, which the assessee failed to do. This led the TPO to treat the ALP of this international transaction at Nil. Normally, if the assessee fails to give any comparable instance, then it becomes the duty of the TPO to search some comparable uncontrolled instances at his own and accordingly determine the ALP of the international transaction. In our view, both the assessee as well the TPO went wrong by not doing what was required to be done by them.

15.4. Once the ALP of an international transaction of purchase of fixed assets is determined, then the difference between the transacted value and the ALP does not directly lead to the transfer pricing adjustment. At this juncture, it is pertinent to note the language of section 92(1) which provides that any income arising from an international transaction shall be computed having regard to the arm's length price. It does not say that the total income is to be computed in accordance with the ALP. It is rightly so because the international transactions which have no direct bearing on the total income, cannot give rise to addition on account of difference between their transacted value and ALP. Since the transaction of purchase of fixed assets is a capital transaction, this, in itself, does not affect the total income of the assessee. It is only the off-shoot of such transaction in the capital field, being depreciation allowance on such ALP of the transaction, which affects the total income. To illustrate, if a fixed asset is purchased by an enterprise from its AE for a sum of Rs.100 and rate of depreciation on such asset is 10%, then the enterprise will charge depreciation amounting to Rs.10 in its Profit and Loss account. If the ALP of such transaction is determined at Rs. 80, then the difference of Rs.20 cannot be considered as income. Rather, the amount of depreciation will be restricted to Rs.8 instead of Rs.10, thereby increasing the total income by Rs.

15.5. Ordinarily an international transaction of purchase of fixed assets by an assessee engaged in a manufacturing or trading business is required to be determined on CUP method, which is usually the most appropriate method in such circumstances. The TNMM on entity level cannot be applied, because the transaction of purchase of fixed assets can have no relation with the transaction of purchase of raw material from AE or sales of goods to AEs. Rule 10A of the IT Rules, defines `transaction’ as including `a number of closely linked transactions’. The Hon’ble Delhi High Court in its judgment of March, 2015 in Sony Ericsson Mobile Communications India Pvt. Ltd. has held that the related transactions should be considered jointly for determining their ALP. However, in order to consider more than one international transaction as one, it is sine qua non that such transactions must be closely and not remotely linked. Every transaction done by an enterprise is somehow or the other linked with the carrying on of the business. But in order to be eligible for processing two or more transactions jointly for determining their ALP, it is essential that they should be closely linked. If two transactions are not closely linked, then they cannot be considered jointly. Considering the above case of a manufacturer or a trader, it cannot be held that the transaction of purchase of fixed assets is closely linked with the purchase of raw material or sale of finished goods etc. In such a scenario, it becomes important to examine the transaction of purchase of fixed assets independent of other transactions.

15.6. However, the above rule of scrutinizing international transaction of purchase of fixed asset as independent of all other transactions is not universal. It has its own exceptions as well. The instant case is a glaring example of exception to the above rule. It is so for the reason that the assessee is getting remuneration from its AE at costs incurred plus a particular mark-up. The cost base includes not only direct but all the indirect costs. The amount of depreciation allowance on fixed assets, including those purchased from AE, is also compensated with the same mark-up. Thus we can say that depreciation allowance and remuneration to the assessee on such depreciation are inseparable transactions. The income in the shape of remuneration to this extent directly depends upon the amount of deprecation allowance. When the assessee is getting mark-up of 13%, the amount of deprecation at Rs.10 in our above hypothetical example will fetch remuneration of Rs.11.30. If the amount of depreciation is reduced to Nil, the amount of income to that extent will also be Nil, because the mark-up can be applied only if there is depreciation cost to the assessee. In other words, the transactions of depreciation on one hand and the resultant revenue on the other, go hand in hand. In such a case, where the income is directly based on the costs incurred including depreciation, then these two transactions become ‘closely linked’ transactions, eligible for processing under the TP provisions on a combined basis. It is illogical to compute the ALP of the transaction of purchase of fixed assets and consequently reduce or nullify the amount of depreciation allowance de hors the consideration of international transaction of the revenue from AE, which is equal to depreciation as claimed with mark-up. Both the transactions of claim of depreciation allowance and revenue of depreciation with mark-up have to be seen jointly. The TPO in the present case has simply reduced the amount of deprecation allowance to Nil without simultaneously considering the revenue side of this transaction. If we consider these closely linked transactions of deduction for depreciation allowance and revenue due to depreciation in unison, the position which follows is that no further addition can be made on account of transfer pricing adjustment due to one- sided consideration of depreciation allowance at Nil. Rather, the determination of ALP of the international transaction of purchase of fixed assets, in the facts and circumstances of the instant case, is tax neutral. As such, we order for the deletion of addition made by disallowing or reducing the amount of depreciation on the assets purchased from AE. This ground is allowed.

GROUND NO.7

GROUND NO.8

GROUND NO.9 60. Ground No.9 needs no adjudication as the same is consequential in nature.

Order pronounced in open court on this 22nd day of March, 2017.