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Income Tax Appellate Tribunal, DELHI BENCHES : I-1 : NEW DELHI
Before: SHRI R.S. SYAL & SHRI KULDIP SINGH
per section 92F(iii) as also including its permanent establishment for the transfer pricing provisions is confined only in respect of a foreign general enterprise having a branch office in India and not vice versa.
Adverting to the facts of the instant case, we find that the extant assessee is also an Indian resident and as such is liable for tax in respect of the income earned in India (through its Head office in India) and also the income accruing from outside India (through its Branch office in Canada). The assessee has rightly offered income for taxation not only the amount earned by the Indian head office, but also whole of the income earned by Canada branch office. This position can be ascertained from the Annual accounts of the assessee, whose copy has been placed on record. Page C-6 of the paper book is copy of the Profit & Loss Account of the assessee, which gives a figure of ‘Revenue from services rendered.’ This figure has been depicted at Rs.45.42 crore. Its break-up is available on page C-19, from where it is discernible that revenue earned by the Indian head office from exports stands at Rs.9.50 crore and revenue of Canadian foreign branch at Rs.35.92 crore. Not only the income but, also the expenses and all the items of balance sheet of branch office, Canada have also been merged with the figures of head office. It is the total income as also including the total revenue earned by branch office Canada, which has been offered for taxation. Under such circumstances and in the backdrop of the foregoing discussion, the transfer pricing provisions cannot apply in respect of transactions between the Indian head office and branch office in Canada. The impugned order is set aside pro tanto.
The next issue raised in this appeal is against the addition due to transfer pricing adjustment amounting to Rs.2,59,26,400/-. Succinctly, the facts apropos this issue are that the assessee entered into international transaction of ‘Software development services’ with its AE, namely, Aithent Inc., USA. The assessee adopted Transactional Net Margin Method (TNMM) as the most appropriate method with Profit level indicator (PLI) of OP/OC. Certain comparables were chosen after applying certain filters, which have been listed on page 3 of the TPO’s order. That is how, the assessee claimed that its international transactions were at ALP. Not satisfied, the AO made reference to the TPO for determination of the ALP of this international transaction. The TPO disagreed with certain filters adopted by the assessee and finally applied the following filters for selecting the comparable companies : -
� Companies whose data is not available for the FY 2007-08 were excluded. � Companies whose Software Development Service revenue is less than 75% of the total operating revenues were excluded. � Companies whose software development service revenue<Rs.1 cr. were excluded. � Companies who have less than 25% of the revenues as export sales were excluded. � Companies who have more than 25% related party transactions (sales as well as expenditure combined) of the operating revenues were excluded. � Companies whose employee cost to revenues is less than 25% of the revenues were excluded.
� Companies having different financial year ending (i.e., not March 31, 2008) or data of the company does not fall within 12 months period i.e., 01.04.2007 to 31.03.2008, were rejected. � Companies who have diminishing revenues/persistent losses for the period under consideration were excluded. � Companies whose onsite income is more than 75% of the export revenues were excluded. � Companies that are functionally different from that of taxpayer.
By applying the above filters, the list of comparables drawn by the assessee underwent change inasmuch as the TPO inducted certain new companies as comparable and also disqualified some of the companies which were considered as comparable by the assessee. The TPO computed arithmetical mean of the finally selected companies (after allowing working capital adjustment) at 24.66%. This arm’s length margin was applied to determine the transfer pricing adjustment amounting to Rs.3.09 crore. The assessee objected to the calculation made by the TPO before the Dispute Resolution Panel (DRP). The DRP vide its order dated 24.9.2012 issued certain directions. Giving effect to the direction given by the DRP, the TPO passed the consequential order on 9.10.2012 down scaling the amount of transfer pricing adjustment to Rs.2.59 crore by way of revision in the arithmetical mean of OP/TC at 20.57% of the surviving 18 companies in the list of comparables. The assessee is aggrieved against the inclusion of several companies in the list of comparables and also the exclusion of some of the companies which were claimed by it as comparable. The main thrust of the ld. AR’s arguments was on the application of some of the above filters, which in his opinion, were not correctly appreciated and resulted into the inclusion of unwarranted companies and the exclusion of certain requisite companies from/in the final list of comparables. The ld. AR urged us to decide on the correctness of some of the filters applied by the authorities below and then remit the matter to the TPO for passing order in the light of our decision on the correctness of such filters. The ld. DR fairly agreed to this proposition. Ex consequenti, we will take up the filters as adopted by the TPO that are under challenge.
(i) Companies whose software development service revenue<Rs.1 crore were excluded.
11.1. The ld. AR contended that the assessee company earned revenue from services to the tune of Rs.45.42 crore. It was submitted that the filter of exclusion of companies with service revenue of less than Rs.1 crore was not fully correct. He did not raise any objection to the application of lower limit of filter at Rs.1 crore, but, challenged the upper limit of turnover, which was left open by the TPO. The ld. AR contended that some sort of cap on the upper limit of turnover should have been considered by the TPO.
11.2. We are not convinced with the argument advanced on behalf of the assessee in this regard. When functionally similar companies are chosen and then average of the profit rate of such similarly functional companies is taken into account for determining the ALP of the international transaction undertaken by the assessee, the size of some of the companies in the whole lot of comparable companies, becomes meaningless. Averaging of the profit rates of the whole lot of functionally similar companies of different sizes, viz., some having higher while some others having lower turnover vis-à-vis the assessee, irons out the effect of such differences. The Hon’ble jurisdictional High Court in the case of ChrysVapital Investment Advisors (India) Pvt. Ltd. vs. DCIT (2015) 376 ITR 183 (Del) has held that high profit/turnover cannot be a criteria to exclude an otherwise comparable company. This issue being no more res integra, does not deserve the acceptance by us of the argument advanced on behalf of the assessee. We, therefore, hold that the TPO was justified in applying this filter.
(ii) Companies who have less than 25% of the revenues as export sales were excluded.
After considering the rival submissions and perusing the relevant material on record, we find that the assessee’s export sales are Rs.9.49 crore as against the total sales of Rs.45.42 crore. This shows that the assessee’s export revenue is roughly 21% of total revenue. If we apply the filter of excluding the companies having less than 25% of the revenue’s from export sales, it would tend to eliminate the companies which are similarly placed as the assessee. In our considered opinion, this filter should not have been applied by the TPO, which has actually upset the selection process. Both the sides agreed that if, in the given circumstances, the filter of excluding the companies with export sales of more than 30% of the total revenue is applied, that would serve the purpose. In our considered opinion, this proposition put forth by the ld. AR and as accepted by the ld. DR, is in order.
(iii) Companies who have more than 25% related party transactions (sales as well as expenditure combined) of the operating revenues were excluded.
13.1. The TPO applied the filter of related party transactions (RPTs) of more than 25% of the operating revenue and accordingly short listed the companies in the final set of comparables. The ld. AR did not dispute the percentage of 25%. He, however, objected to the application of this 25% related party transactions to ‘sales as well as expenditure combined.’ 13.2. Having heard the rival submissions and perused the relevant material on record, we find that the TPO has included sales as well as expenses in a combined manner as numerator with the denominator of operating revenue. This approach, in our considered opinion, is not correct. The percentage of numerator to denominator can be rightly calculated only when the contents of a part representing the RPT of a particular nature is seen with reference to the contents of whole of that nature. Both the numerator and denominator need to have the same nature of contents. This can be done by segregating transactions of one nature, like, comparing RPT of purchase with the total purchases or RPT of sales with the total amount of sales of the company. It is also possible to club small transactions of a distinct but related income producing activity with a large transactions of major income producing activity as one unit, both in the numerator as well as in the denominator. For example, RPT of major sale transaction and minor job income can be combined to find out the percentage of RPTs with the total of sales and job income taken together. This entire exercise can be done by firstly calculating the percentage of RPT purchases with total purchases and then of RPT sales and service income as one unit with the total of sales and service income again as one unit. The decision as to whether a company should be included in the list of comparables by applying the filter of more than 25% RPTs, would depend on the outcome of two such percentages of RPTs. If either of the two breaches the 25% threshold, then the company will cease to be comparable. The impugned order, combining sales and expenses, for calculating the percentage of the RPTs is set aside to this extent and the TPO is, accordingly, directed to apply this filter in the manner discussed above.
(iv) Companies who have diminishing revenues/persistent losses for the period under consideration were excluded.
14.1. The TPO applied this filter for excluding the companies from the final set of comparables which were having diminishing revenues or persistent losses. The ld. AR argued that this filter ought not to have been applied. This was controverted by the ld. DR who submitted that the Delhi Bench of the Tribunal in the case of Navisite India has approved this filter.
14.2. After considering the rival submissions and perusing the relevant material on record, we find the position of profit/loss earned by the assessee during the period relevant to the assessment year under consideration and six earlier years is as under:-
Financial Year Profit/loss (as per Audited Financials) 2001-02 2,81,18,307 2002-03 -5,58,88,557 2003-04 -7,62,57,307 2004-05 -4,85,47,772 2005-06 -1,32,74,909 2006-07 92,74,632 2007-08 62,39,414 14.3. A careful perusal of the pattern of profit/loss earned by the assessee as per its audited accounts divulges that as against the current year’s profit of Rs.62.39 lac, the earlier years’ profit was Rs.92.74 lac.
This manifests that the profit for this year has diminished from the earlier year. When we consider the figures of losses for the financial years 2005-06 and earlier years, it comes to light that there were losses right from financial year 2002-03 up to 2005-06. On an overview of the above extracted Table, it can be seen that the assessee’s profit is not steady, but, has diminished during the instant year from the preceding year. In such a situation, if we exclude the companies having diminishing profits, it would mean that the companies whose profit pattern is also similar to that of the assessee would face the axe. Doing so would mean excluding the comparable companies from the final tally, which is not appropriate. However, the companies having persistent losses, obviously, cannot be compared with the assessee because it has earned positive income not only in this year, but, in the preceding year as well. We, therefore, hold that the companies having diminishing revenue should not be excluded, but, only the companies having persistent losses should be expelled from the final tally of comparables.
(v) Companies whose onsite income is more than 75% of the export revenues were excluded.
15.1. The TPO excluded the companies whose onsite income was more than 75% of the export revenues. The ld. AR argued that the income earned by branch office, Canada was largely onsite income and, hence, this filter could not be applied. In support of his contention of the branch office, Canada earning onsite income, he placed on record certain agreements which show the rendering of onsite services by the branch office, Japan. The DR, however, opposed the argument of the ld. AR.
15.2. Having heard the rival submissions and perused the relevant material on record, we find that out of total revenue of Rs.45.42 crore earned by the assessee, its revenue of the foreign branch is to the tune of Rs.35.92 crore, which is roughly 80% of the total revenue. The ld. AR contended that the entire income earned by branch office, Canada, was from rendering onsite services. However, this proposition could be substantiated partly as only 2-3 copies of agreements entered into by the branch office, Canada with its clients were furnished as against numerous clients. If the argument of the ld. AR is correct that its foreign branch earned only onsite services income, then, the filter applied by the TPO excluding the companies whose onsite income is more than 75% of the export revenues, becomes meaningless. In such a situation, the companies whose onsite income is more than 75% of the export limit should be rather included. Since the necessary complete information is not available with the ld. AR for verifying the veracity of the contention of the foreign branch earning 100% onsite services, we consider it expedient to direct the TPO/AO to examine the break-up of the revenues earned by branch office, Canada, for seeing if the same is from onsite/offsite services. The application of the filter will be then decided accordingly by the TPO.
Having discussed the applicability or otherwise of the filters applied by the TPO as challenged before us, we now set aside the impugned order and remit the matter to the file of TPO/AO for considering the comparability or otherwise of the companies disputed by the assessee on the touchstone of the discussion made above and then determining the ALP of the international transaction.
The other objection taken by the ld. AR against the determination of ALP under this segment is in not allowing adjustment on account of idle capacity. The assessee claimed that during the year 42% of its employees remained idle and, hence, sought reduction in its operating cost to the extent of such extraordinary expense. The TPO jettisoned this proposition. The assessee now seeks reduction in its operating costs on account of such idle labour cost for the purposes of computing the transfer pricing adjustment.
We have heard both the sides and perused the relevant material on record. It is obvious that the TPO used the TNMM as the most appropriate method for calculating the ALP of this transaction, which was also considered by the assessee as the most appropriate method.
The mechanism for determining the ALP under this method has been set out in Rule 10B(1)(e) as under:-
(e) transactional net margin method, by which,— (i) the net profit margin realised by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base ; (ii) the net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base ;
(iii) the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market ; (iv) the net profit margin realised by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii) ; (v) the net profit margin thus established is then taken into account to arrive at an arm’s length price in relation to the international transaction.
It can be noticed from sub-clause (i) that the net profit margin realized by the enterprise from an international transaction is computed in relation to the costs incurred or sales effected, etc. Sub-clause (ii) talks of determining the net profit margin realized from comparable uncontrolled transactions. Sub-clause (iii) speaks of adjusting the net profit margin realized from comparable uncontrolled transactions determined in sub-clause (ii) by taking into account the differences, if any, between the international transaction and the comparable uncontrolled transactions. It is obvious from sub-clause (i) that the net profit margin actually realized by the assessee is always taken as such without any adjustment. The effect of differences between the international transaction and comparable uncontrolled transactions is always given in the net operating profit margin of the comparable uncontrolled transactions. There is no mandate for adjusting the assessee’s profit margin under the provisions of Rule 10B(1)(e). The assessee’s contention that its operating costs should be reduced to the extent its employees remained idle is, ergo, incapable of acceptance.
The adjustment, if any, could have been allowed, if the assessee had demonstrated that the comparable companies had more under-utilization of their labour force vis-à-vis the assessee. The onus to prove such under-utilization of employees of the comparables, for claiming adjustment, squarely lies on the assessee. On a specific query, the ld. AR could not point out that the utilization of employees by the comparable companies was less than the assessee. Under such circumstances, we are of the considered opinion that no such adjustment can be granted. We, therefore, approve the view taken by the authorities on this issue.
In the result, the appeal is allowed for statistical purposes.
The order pronounced in the open court on 21.09.2016.