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Income Tax Appellate Tribunal, “C” BENCH : BANGALORE
Before: SMT. ASHA VIJAYARAGHAVAN & SHRI ABRAHAM P. GEORGE
Per Asha Vijayaraghavan, Judicial Member
This appeal is by the assessee company directed against the order dated 27.01.2015 of the CIT(Appeals)-4, Bangalore for the assessment year 2009-10.
The assessee company is a subsidiary of Moog Inc., USA and provides software development services to its Associated Enterprise (AE).
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The assessee is also engaged in the manufacture and sale of servo control mechanisms and components. During the F.Y. 2008-09, the assessee had
entered into following international transactions with AEs:-
The margins earned by the assessee for the F.Y. 2008-09 are as
follows:-
The following are the comparable companies selected by the assessee in the TP documentation regarding its software development
activity:-
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The assessee earned an OP/TC of 14.60 percent for FY 2008-09, with
respect to the provision of software development services to its AEs. As the OP/TC of 14.60 percent was higher than the average OP/TC earned by
comparable companies identified in the transfer pricing report, it was concluded that the international transactions were at arm’s length.
The comparable companies selected by the TPO in his TP order for
the AY 2009-10 are as follows:-
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The arm’s length price (ALP) worked out by the TPO was as under:-
Aggrieved by the order of the lower authorities, the assessee is in
appeal before us on the following grounds of appeal:-
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“1. The learned Assessing Officer (“AO”), the learned Deputy Commissioner of Income Tax (Transfer Pricing Officer — II), Bangalore (“Transfer Pricing officer” or “TPO”) and the Honourable Commissioner of Income Tax (Appeals) (“Hon’ble CIT (A)”) have erred in law and facts of the case in proposing a transfer pricing adjustment under section 92CA of the Income-tax Act, 1961 (“the Act”) amounting to Rs. 91,03,983/- in relation to the provision of software development services to the Associated Enterprises (“AEs”). 2. The learned Assessing Officer (“AO”), Transfer Pricing Officer (“TPO”) and Hon’ble CIT(A) have erred in disregarding the economic analysis performed by the Appellant in the Transfer Pricing (‘TP’) documentation justifying the arm’s length nature of the international transactions with the AEs. 3. The learned AO, TPO and Hon’ble CIT(A) have erred in rejecting the TP documentation of the Appellant contending the same is defective and not reliable. 4. The learned AO, TPO and Hon’ble CIT(A) (A) have erred in not considering multiple year/prior year data of comparable companies while determining arm’s length price. 5. The learned AO, TPO and Hon’ble CIT(A) erred in using data as at the time of assessment proceedings, instead of that available as on the date of preparing the TP documentation for comparable companies while determining arm’s length price. 6. The learned AO, TPO and Hon’ble CIT(A) have erred in rejecting companies selected as comparable by the Appellant in the TP documentation and have erred in selecting/introducing companies which are not comparable to the Appellant on conducting a fresh comparability analysis and on introduction of additional filters in determination of arm’s length price. 7. The learned AO, TPO and Hon’ble CIT(A) have erred in rejecting Thinksoft Global Services Ltd. and FCS Software Solutions Ltd. on the ground that the working capital adjustment for these companies are substantial. 8. The learned AO, TPO and Hon’ble CIT(A) have erred in not rejecting Bodhtree Consulting Ltd. and Kals Information Systems Ltd. being functionally dissimilar to the Appellant.
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The learned AO, TPO and Hon’ble CIT(A) have erred in ignoring the limited risk nature of the contractual services provided by the Appellant and in not providing an appropriate adjustment towards the risk differential, even when the full- fledged entrepreneurial companies are selected as comparable companies. 10. The learned AO, TPO and Hon’ble CIT(A) have erred in applying an upper cap in grant of working capital adjustment. 11. The Appellant retains the right to have the benefit of applying the range of +1- 5% in determination of arm’s length price.”
The final set of 11 comparable companies selected by the TPO are as follows:-
Sl. Name of company Sales (in Rs.) Cost Margin No (in Rs.) 1 Kals Information 2,14,04,686 1,87,93,813 13.89% System Ltd. 2 Akshay Software 12,23,21,483 11,31,49,350 8.11% Technologies Ltd. 3 Bodhtree Consulting 16,05,75,212 9,89,56,821 62.27% Ltd. 4 R S Software (India) 1,49,57,12,634 1,36,01,02,589 9.97% Ltd. 5 Tata Elxsi Ltd. 3,78,43,03,000 3,14,63,15,000 20.28% (Seg.) Sasken Communication 6 4,05,31,20,000 3,18,69,97,000 27.91% Technologies Ltd. 7 Persistent Systems 5,19,69,10,000 3,67,52,70,000 41.40% Ltd. 8 Zylog Systems Ltd. 7,34,93,51,475 6,81,69,98,160 7.81% 9 Mindtree Ltd. (Seg.) 7,93,22,79,326 5,74,06,73,058 5.52% 10 Larsen & Toubro 19,50,83,81,374 15,64,12,76,626 24.72% Infotech 11 Infosys Ltd. 2,02,64,00,00,000 1,39,17,00,00,000 45.61% AVERAGE MEAN 24.32%
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With respect to Sl.Nos.5, 6, 7, 8, 9, 10 & 11 of the final list of comparables selected by the TPO, the ld. counsel for the assessee pleaded that these comparables have to be rejected since the turnover filter is more than Rs.200 crores.
It has been held by this Tribunal in the case of Trilogy E-Business Software India Pvt. Ltd. in ITA No.1054/Bang/2011 dated 23.11.2012 that companies with a turnover of more than Rs.200 crores cannot be taken as comparables while determining the ALP in the case of companies having turnover of less than Rs.200 crores. The following are the relevant observations of the Tribunal in this regard:-
“(1) Turnover Filter
The ld. counsel for the assessee submitted that the TPO has applied a lower turnover filter of RS. 1 crore, but has not chosen to apply any upper turnover limit. In this regard, it was submitted by him that under rule 10B(3) to the Income-tax Rules, it was necessary for comparing an uncontrolled transaction with an international transaction that there should not be any difference between the transactions compared or the enterprises entering into such transaction, which are likely to materially affect the price or cost charged or paid or profit arising from such transaction in the open market. Further it is also necessary to see that wherever there are some differences such differences should be capable of reasonable accurate adjustment in monetary terms to eliminate the effect of such differences. It was his submission that size was an important facet of the comparability exercise. It was submitted that significant differences in size of the companies would impact comparability. In this regard our attention was drawn to the decision of the Special Bench of the ITAT Chandigarh Bench in the case of DCIT v. Quark Systems
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Pvt. Ltd. 38 SOT 207, wherein the Special Bench had laid down that it is improper to proceed on the basis of lower limit of 1 crore turnover with no higher limit on turnover, as the same was not reasonable classification. Several other decisions were referred to in this regard laying down identical proposition. We are not referring to those decisions as the decision of the Special Bench on this aspect would hold the field. Reference was also made to the OECD TP Guidelines, 2010 wherein it has been observed as follows:- “Size criteria in terms of Sales, Assets or Number of Employees: The size of the transaction in absolute value or in proportion to the activities of the parties might affect the relative competitive positions of the buyer and seller and therefore comparability.” 12. The ICAI TP Guidelines note on this aspect lay down in para 15.4 that a transaction entered into by a Rs. 1,000 crore company cannot be compared with the transaction entered into by a Rs. 10 crore company. The two most obvious reasons are the size of the two companies and the relative economies of scale under which they operate. The fact that they operate in the same market may not make them comparable enterprises. The relevant extract is as follows [on Rule 10B(3)]: “Clause (i) lays down that if the differences are not material, the transactions would be comparable. These differences could either be with reference to the transaction or with reference to the enterprise. For instance, a transaction entered into by a Rs 1,000 crore company cannot be compared with the transaction entered into by a Rs 10 crore company. The two most obvious reasons are the size of the two companies and the relative economies of scale under which they operate.” 13. It was further submitted that the TPO’s range (Rs. 1 crore to infinity) has resulted in selection of companies like Infosys which is 277 times bigger than the Assessee (turnover of Rs. 13,149 crores as compared to Rs. 47.47 crores of Assessee). It was submitted that an appropriate turnover range should be applied in selecting comparable uncontrolled companies.
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Reference was made to the decision of the ITAT Bangalore Bench in the case of Genesis Integrating Systems (India) Pvt. Ltd. v. DCIT, ITA No.1231/Bang/2010, wherein relying on Dun and Bradstreet’s analysis, the turnover of RS. 1 crore to RS. 200 crores was held to be proper. The following relevant observations were brought to our notice:- “9. Having heard both the parties and having considered the rival contentions and also the judicial precedents on the issue, we find that the TPO himself has rejected the companies which .ire (sic) making losses as comparables. This shows that there is a limit for the lower end for identifying the comparables. In such a situation, we are unable to understand as to why there should not be an upper limit also. What should be upper limit is another factor to be considered. We agree with the contention of the learned counsel for the assessee that the size matters in business. A big company would be in a position to bargain the price and also attract more customers. It would also have a broad base of skilled employees who are able to give better output. A small company may not have these benefits and therefore, the turnover also would come down reducing profit margin. Thus, as held by the various benches of the Tribunal, when companies which arc loss making are excluded from comparables, then the super profit making companies should also be excluded. For the purpose of classification of companies on the basis of net sales or turnover, we find that a reasonable classification has to be made. Dun & Bradstreet & Bradstreet and NASSCOM have given different ranges. Taking the Indian scenario into consideration, we feel that the classification made by Dun & Bradstreet is more suitable and reasonable. In view of the same, we hold that the turnover filter is very important and the companies having a turnover of Rs.1.00 crore to 200 crores have to be taken as a particular range and the assessee being in that range having turnover of 8.15 crores, the companies which also have turnover of 1.00 to 200.00 crores only should be taken into consideration for the purpose of making TP study.”
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It was brought to our notice that the above proposition has also been followed by the Honourable Bangalore ITAT in the following cases: 1. M/s Kodiak Networks (India) Private Limited Vs. ACIT (ITA No.1413/Bang/2010) 2. M/s Genesis Microchip (I) Private Limited Vs. DCIT (ITA No.1254/Bang/20l0). 3. Electronic for Imaging India Private Limited (ITA No. 1171/Bang/2010). It was finally submitted that companies having turnover more than Rs. 200 crores ought to be rejected as not comparable with the Assessee. 16. The ld. DR, on the other hand pointed out that even the assessee in its own TP study has taken companies having turnover of more than RS. 200 crores as comparables. In these circumstances, it was submitted by him that the assessee cannot have any grievance in this regard. 17. We have considered the rival submissions. The provisions of the Act and the Rules that are relevant for deciding the issue have to be first seen. Sec.92. of the Act provides that any income arising from an international transaction shall be computed having regard to the arm’s length price. Sec.92-B 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 provision of services, or lending or borrowing money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises, and shall include a mutual agreement or arrangement between two or more associated enterprises for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any one or more of such enterprises. Sec.92- A defines what is an Associated Enterprise. In the present case there is no dispute that the transaction between the Assessee and its AE was an international transaction attracting the provisions of Sec.92 of the Act. Sec.92C provides the manner of
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computation of Arm’s length price in an international transaction and it provides:- (1) that the arm’s length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method, having regard to the nature of transaction or class of transaction or class of associated persons or functions performed by such persons or such other relevant factors as the Board may prescribe, namely :— (a) comparable uncontrolled price method; (b) resale price method; (c) cost plus method; (d) profit split method; (e) transactional net margin method; (f) such other method as may be prescribed by the Board.
(2) The most appropriate method referred to in sub- section (1) shall be applied, for determination of arm’s length price, in the manner as may be prescribed: Provided that where more than one price is determined by the most appropriate method, the arm’s length price shall be taken to be the arithmetical mean of such prices:
Provided further that if the variation between the arm’s length price so determined and price at which the international transaction has actually been undertaken does not exceed five per cent of the latter, the price at which the international transaction has actually been undertaken shall be deemed to be the arm’s length price.
(3) Where during the course of any proceeding for the assessment of income, the Assessing Officer is, on the basis of material or information or document in his possession, of the opinion that— (a) the price charged or paid in an international transaction has not been determined in accordance with sub-sections (1) and (2); or
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(b) any information and document relating to an international transaction have not been kept and maintained by the assessee in accordance with the provisions contained in sub-section (1) of section 92D and the rules made in this behalf; or (c) the information or data used in computation of the arm’s length price is not reliable or correct; or (d) the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by a notice issued under sub-section (3) of section 92D, the Assessing Officer may proceed to determine the arm’s length price in relation to the said international transaction in accordance with sub-sections (1) and (2), on the basis of such material or information or document available with him:”
Rule 10B of the IT Rules, 1962 prescribes rules for Determination of arm’s length price under section 92C:- “10B. (1) For the purposes of sub-section (2) of section 92C, the arm’s length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method, in the following manner, namely :— (a)……. to (d)…….. (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;
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(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.
(2) For the purposes of sub-rule (1), the comparability of an international transaction with an uncontrolled transaction shall be judged with reference to the following, namely:— (a) the specific characteristics of the property transferred or services provided in either transaction; (b) the functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to the transactions; (c) the contractual terms (whether or not such terms are formal or in writing) of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions; (d) conditions prevailing in the markets in which the respective parties to the transactions operate, including the geographical location and size of the markets, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development
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and level of competition and whether the markets are wholesale or retail.
(3) An uncontrolled transaction shall be comparable to an international transaction if—
(i) none of the differences, if any, between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from, such transactions in the open market; or (ii) reasonably accurate adjustments can be made to eliminate the material effects of such differences.
(4) The data to be used in analysing the comparability of an uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered into : Provided that data relating to a period not being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared.”
A reading of the provisions of Rule 10B(2) of the Rules shows that uncontrolled transaction has to be compared with international transaction having regard to the factors set out therein. Before us there is no dispute that the TNMM is the most appropriate method for determining the ALP of the international transaction. The disputes are with regard to the comparability of the comparable relied upon by the TPO. 20. In this regard we find that the provisions of law pointed out by the ld. counsel for the assessee as well as the decisions referred to by the ld. counsel for the assessee clearly lay down the principle that the turnover filter is an important criteria in choosing the comparables. The assessee’s turnover is RS.
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47,46,66,638. It would therefore fall within the category of companies in the range of turnover between 1 crore and 200 crores (as laid down in the case of Genesis Integrating Systems (India) Pvt. Ltd. v. DCIT, ITA No.1231/Bang/2010) . Thus, companies having turnover of more than 200 crores have to be eliminated from the list of comparables as laid down in several decisions referred to by the ld. counsel for the assessee. Applying those tests, the following companies will have to be excluded from the list of 26 comparables drawn by the TPO viz., Turnover Rs. (1) Flextronics Software Systems Ltd. 848.66 crores (2) iGate Global Solutions Ltd. 747.27 crores (3) Mindtree Ltd. 590.39 crores (4) Persistent Systems Ltd. 293.74 crores (5) Sasken Communication Technologies Ltd. 343.57 crores (6) Tata Elxsi Ltd. 262.58 crores (7) Wipro Ltd. 961.09 crores. (8) Infosys Technologies Ltd. 13149 crores.”
Respectfully following the decision of the Tribunal referred to above, we direct that Infosys Ltd., Flextronics Software Systems Ltd., iGate Global Solutions Ltd., Mindtree Consulting Ltd., Persistent Systems Ltd., and Sasken Communication Ltd., are to be excluded as comparables for the purpose of determining the ALP of the impugned transaction in this appeal.” 11. Following the decision of the Tribunal in the case of Trilogy E- Business Software India Pvt. Ltd. in ITA No.1054/Bang/2011 dated 23.11.2012, these 7 companies viz., Tata Elxsi Ltd. (Seg.); Sasken Communication Ltd. (Seg); Persistent Systems Ltd.; Zylog Systems Ltd.; Mindtree Ltd.; Larsen and Toubro Infotech (Seg.) and Infosys Technologies Ltd., are directed to be excluded from the list of comparables chosen by the TPO.
With respect to KALS Information Systems Ltd., the ld. counsel for the assessee stated that the assessee had accepted the same as a
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comparable before the CIT(Appeals), but it is now sought to be rejected as a comparable on the ground that it is functionally dissimilar. It was also contended that the company is into development of software products and there is presence of significant inventory. The ld. counsel for the assessee relied on the decision of CISCO Systems (India) Pvt. Ltd. in IT(TP)A No.271/Bang/2014, order dated 14.08.2014, wherein it was held as follows:-
26.3 KALS Information Systems Ltd.:- As far as this company is concerned, it is not in dispute before us that this company has been considered as not comparable to a pure software development services company by the Bangalore Bench of the Tribunal in the case of M/s. Trilogy e-business Software India Pvt. Ltd. (supra). The following were the relevant observations of the Tribunal:- “(d) KALS Information Systems Ltd. 46. As far as this company is concerned, the contention of the assessee is that the aforesaid company has revenues from both software development and software products. Besides the above, it was also pointed out that this company is engaged in providing training. It was also submitted that as per the annual repot, the salary cost debited under the software development expenditure was Rs. 45,93,351. The same was less than 25% of the software services revenue and therefore the salary cost filter test fails in this case. Reference was made to the Pune Bench Tribunal’s decision of the ITAT in the case of Bindview India Private Limited Vs. DCI, ITA No. ITA No 1386/PN/1O wherein KALS as comparable was rejected for AY 2006-07 on account of it being functionally different from software companies. The relevant extract are as follows: “16. Another issue relating to selection of comparables by the TPO is regarding inclusion of Kals Information System Ltd. The assessee has objected to its inclusion on the basis that functionally the company is not comparable. With reference to pages 185-186 of the
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Paper Book, it is explained that the said company is engaged in development of software products and services and is not comparable to software development services provided by the assessee. The appellant has submitted an extract on pages 185-186 of the Paper Book from the website of the company to establish that it is engaged in providing of I T enabled services and that the said company is into development of software products, etc. All these aspects have not been factually rebutted and, in our view, the said concern is liable to be excluded from the final set of comparables, and thus on this aspect, assessee succeeds.” Based on all the above, it was submitted on behalf of the assessee that KALS Information Systems Limited should be rejected as a comparable. 47. We have given a careful consideration to the submission made on behalf of the Assessee. We find that the TPO has drawn conclusions on the basis of information obtained by issue of notice u/s.133(6) of the Act. This information which was not available in public domain could not have been used by the TPO, when the same is contrary to the annual report of this company as highlighted by the Assessee in its letter dated 21.6.2010 to the TPO. We also find that in the decision referred to by the learned counsel for the Assessee, the Mumbai Bench of ITAT has held that this company was developing software products and not purely or mainly software development service provider. We therefore accept the plea of the Assessee that this company is not comparable.”
Following the aforesaid decision of the Tribunal in the case of CISCO Systems (India) Pvt. Ltd. (supra), we are of the opinion that KALS Information Systems Ltd. is functionally dissimilar to that of the assessee and hence it is not to be regarded as a comparable.
With respect to Bodhtree Consulting Ltd., the CIT(Appeals) had accepted the same as a comparable. The CIT(Appeals) relied on the
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decision of the Bangalore Bench decision in the case of Trilogy E-Business Software India (P.) Ltd. (supra) and 24/7 Customer.com (P) Ltd. 28
taxmann.com 258 (Bang). The CIT(A) observed that in the above decisions it has been made clear that there is no bar in considering
companies with abnormal profits/losses as comparables unless the
assessee demonstrates and establishes that some abnormal event took place which led to abnormal results. Hence, the CIT(A) rejected the
contentions of the assessee for exclusion of Bodhtree Consulting Ltd. as a comparable.
The assessee has now raised grounds before us stating that the
same is functionally dissimilar which is into development of software products. The ld. counsel for the assessee also stated that there is
mismatch on the revenue-cost. Reliance was placed on the decision of the Bangalore Bench of the Tribunal in the case of CISCO Systems (India)
Pvt. Ltd. (supra) and Delhi Bench of the Tribunal’s decision in Ciena India
Pvt. Ltd., ITA No.1453/Del/2014 respectively.
We have heard both the parties and perused the material on record.
In the case of CISCO Systems (India) Pvt. Ltd. (supra), the coordinate Bench of this Tribunal held that Bodhtree Consulting Ltd. is not to be
treated as a comparable company. In this regard, the relevant
observations of the Tribunal on the functional dissimilarity are as under:-
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“26.1 Bodhtree Consulting Ltd.:- As far as this company is concerned, it is not in dispute that in the list of comparables chosen by the assessee, this company was also included by the assessee. The assessee, however, submits before us that later on it came to the assessee’s notice that this company is not being considered as a comparable company in the case of companies rendering software development services. In this regard, the ld. counsel for the assessee has brought to our notice the decision of the Mumbai Bench of the Tribunal in the case of Nethawk Networks Pvt. Ltd. v. ITO, ITA No.7633/Mum/2012, order dated 6.11.2013. In this case, the Tribunal followed the decision rendered by the Mumbai Bench of the Tribunal in the case of Wills Processing Services (I) P. Ltd., ITA No.4547/Mum/2012. In the aforesaid decisions, the Tribunal has taken the view that Bodhtree Consulting Ltd. is in the business of software products and was engaged in providing open & end to end web solutions software consultancy and design & development of software using latest technology. The decision rendered by the Mumbai Bench of the Tribunal in the case of Nethawk Networks Pvt. Ltd. (supra) is in relation to A.Y. 2008- 09. It was affirmed by the learned counsel for the Assessee that the facts and circumstances in the present year also remains identical to the facts and circumstances as it prevailed in AY 08- 09 as far as this comparable company is concerned. Following the aforesaid decision of the Mumbai Bench of the Tribunal, we hold that Bodhtree Consulting Ltd. cannot be regarded as a comparable. In this regards, the fact that the assessee had itself proposed this company as comparable, in our opinion, should not be the basis on which the said company should be retained as a comparable, when factually it is shown that the said company is a software product company and not a software development services company.
In the case of Ciena India Pvt. Ltd. (supra), the Delhi Bench of the Tribunal with respect to mismatch in the revenue cost held as under:-
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“9.6 Coming back to the facts of the instant case, we find from Schedule 12 that there is a mention of Significant accounting policy at Sl. no.3, which provides that : “Revenue from software development is recognized based on software development and billed to clients.” If some software development project is incomplete at the end of the year, this Note may entail two situations , viz., the first, in which the expenses incurred in respect of such software development may be capitalized, which appears to be a more rational manner of depicting the true and fair view of the profitability of the enterprise; and the second, in which such expenses may be straightway taken as revenue cost for the year of its incurring itself, which may not reflect a true and fair view of the profits on year to year basis. The contention of the ld. AR is that whereas Bodhtree fell into the second situation, the assessee was in the first situation. Though this contention about Bodhtree accounting for expenses in the year of incurring but considering income only on the conclusion of the project in the subsequent year sounded a little awkward, we attempted to find out the amount of capitalized expenses in respect of incomplete projects at the end of the year. Apparently, we could not find out any such capitalized value of work-in- progress in the balance sheet of the company on standalone basis. We directed the ld. DR to examine the Annual report of this company and point out the amount of expenses capitalized in respect of incomplete work at the end of the year. On the next date of hearing, the ld. DR failed to specifically point out any amount of such capitalized expenses with the opening or closing balance. This prima facie shows that the expenses incurred in respect of incomplete projects of software development at the end of the year, but billed in the subsequent year, were, in fact, treated as expenses for the current year alone. In the same manner, expenses incurred in the preceding year for the contracts of software development remaining incomplete at the end of the year, also must have been included in the expenses of the last year alone, but, the income getting recognized on the raising of bills in the current year. This albeit, patently deforms the correct profitability on year to year basis, yet, but we cannot help the situation. When the position of accounts of Bodhtree is such that it does not properly match expenses with revenue, it loses its credibility for making a logical comparison with a company that accounts for expenses matching with the revenue. Once it is held that the profits of Bodhtree Consulting Ltd. do not represent fair
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profitability on year to year basis, this company loses its tag of an effective comparable. We, therefore, order for the exclusion of this company from the final list of comparables.”
Respectfully following the decisions of the Tribunal in the case of CISCO Systems (India) Pvt. Ltd. (supra) and Ciena India Pvt. Ltd. (supra), we are of the opinion that Bodhtree Consulting Ltd. is to be excluded from the list of comparables selected by the TPO.
With respect to Akshay Software Technologies Ltd. and R.S. Software (India) Ltd., no objection has been raised by the assessee even before us. Hence these two companies are to be retained as comparables.
The ld. counsel for the assessee thereafter stated that market risk adjustment should be allowed and argued that the comparable companies selected by the TPO are independent, risk-bearing entities, whereas the assessee is a captive service provider assuming minimum risk. In the open market, any entity assuming increased risk will also be compensated by an increase in the expected return in the long run. Hence it is essential to perform a risk adjustment to bridge the disparities in risk profile.
It was submitted that in the case of lntellinet Technologies India Private Ltd., ITA No.1237/Bang/2010, order dated 30.03.2012, the jurisdictional Bench of ITAT has held that the single customer risk borne by a captive service provider is only an ‘anticipated’ risk vis-a-vis the ‘existing’
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market risk borne by independent comparables. and has allowed market risk adjustment.
In the case of lntellinet Technologies India Private Ltd., the coordinate Bench of this Tribunal held as under:-
“7. Having heard both the parties and having considered the rival contentions, we find that the assessee has claimed the risk adjustment which is not allowed by the TPO on the ground that the assessee also has the risk of having a single customer. The question before us is as to whether the risk of having a single customer is equivalent to the marketing and technical risk attached to the comparables. According to the TPO, the assessee has the ‘single customer risk’ meaning, if the single customer refuses to have any dealings with the assessee, the assessee would lose all of its business and there would be no profit at all. But, as we see it, the risk of having a single customer is anticipated risk which may or may not happen. What we have to see is the position in the relevant period whether the assessee had encountered such a risk during the relevant period. 7.1 As seen from the records, the assessee had acquired the business and also earned income out of the said transaction by cost plus basis. Thus, it can be seen that the assessee has not encountered the risk of having a single customer, whereas the same cannot be said as regards the comparables. As pointed out by the learned counsel for the assessee, the comparables were dealing in open market and therefore, they were prone to the marketing and technical risks. They would have incurred certain expenditure on marketing services and also to safeguard the technical use by them. In such a case, the risk encountered by the assessee cannot be said to be the equivalent risks attached to the comparables. The risk attributed to the assessee by the TPO is an anticipated risk whereas the risk attributed by the assessee to the comparables is an existing risk. In such situation, the TPO ought to have given the risk adjustment to the net margin of the comparables for bringing them on par with the assessee company. The assessee’s contention that the risk adjustment should be at 5.5% or at the difference of prime lending rate of the RBI and the banks is not acceptable to us. Therefore, we direct the TPO to
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consider all the contentions of the assessee and after taking into account all the relevant material decide the percentage of risk adjustment to be made in accordance with law. This ground is accordingly, allowed for statistical purposes.”
Following the decision of the coordinate Bench of this Tribunal cited supra, we are of the opinion that the TPO has to verify whether comparable companies remaining after the exclusions are independent risk bearing entities or captive service providers. Risk adjustment can be allowed only in case the former condition is satisfied and such risk adjustment if required has to be worked out based on scientific analysis and data. Hence this issue is set aside to the TPO.
The next contention of the assessee is that the working capital adjustment should not have an upper limit. It was submitted that the average cost of capital cannot be used as a upper threshold for working capital adjustment.
The TPO in the order has stated that the profit margin computed in TNMM is a composite figure which includes two components. They are the profit margin on account of operating profit and profit margin on account of cost of capital recovered. Therefore, when the arithmetical average of net profit margins computed in the case of uncontrolled comparables is considered as arm’s length profit margin in transfer pricing that arise from operating business, then the average cost of capital computed in the case of uncontrolled comparables should also be considered as arm’s length price of the cost of capital in transfer pricing exercise. Accordingly, the
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average cost of capital computed in the case of the uncontrolled comparables should be an upper cap for the purpose of allowing working
capital adjustment.
It was submitted that the TPO in the order has advocated limiting the
working capital adjustment contending that the adjustment would be
negative for the assessee/tested party, since it does not have significant debtors/inventory and generally, the assessee/tested party receives the
money in advance for the services from the AEs. Whereas, the entrepreneurial companies selected as comparable will have debtors,
inventory and the creditors.
The ld. counsel for the assessee submitted that in advocating this principle the TPO has ignored the characterisation of the assessee as a
low risk captive services provider that does not perform entrepreneurial functions and consequently does not bear related risks. The assessee,
being part of the larger group has the advantage of healthy working capital
position, whereas, entrepreneurial companies cannot have that advantage and therefore, need to adjust their prices for the services accordingly to
account for working capital related functions, costs and risks. The objective of a benchmarking analysis is to neutralise these differences and bring
about an appropriate comparison as far as possible. According to the ld. counsel for the assessee, even Rule 10B says that reasonable and
appropriate adjustment needs to be made for a better comparability
between the transactions being compared.
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It was further submitted that the TPO ignored the above principles of comparability and contested that the transfer price of uncontrolled independent companies have component of return for functions and return for working capital. It was submitted that though the assessee is not denying this fact, but the return for working capital position between the assessee and the companies selected as comparable vary due to their characterisation and there exists a methodology which is also well accepted internationally to nullify these differences. Therefore, it was submitted that such an adjustment should be carried out to bring in appropriate comparability between the tested party and the companies selected as comparable without any upper cap, which is not based on any sound rationale. The ld. counsel for the assessee relied on the decision of the Mumbai Bench of the Tribunal in the case of Dresser-Rand India Pvt. Ltd. v. ACIT (ITA No.8753/Mum/2010) has held that “The soul of an order is in its reasoning, and unless the reasons for coming to a conclusion in the order are not set out, it is not possible to do a meaningful scrutiny of the order.” The Mumbai Bench in the above case has referred to the observations made by Hon’ble Supreme Court in the case of Union of India vs. Mohan Lal Capoor (AIR 1974 SC 87) wherein Their Lordships have, inter alia, observed as follows:-
“If the statute requires recording of reasons, then it is the statutory requirement and, therefore, there is no scope for further inquiry. But even when the statute does not impose such an obligation it is necessary for the quasi-judicial authorities to record reason as it is only visible safeguard against possible
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injustice and arbitrariness and affords protection to the person adversely affected. Reasons are the links between the material on which certain conclusions are based and the actual conclusions. They disclose how the mind is applied to the subject-matter for a decision, whether it is purely administrative or quasi-judicial. They should reveal rational nexus between the facts considered and the conclusion reached. Only in this way can opinions or decisions recorded be shown to be manifestly just and reasonable.
In view of the decision in the case of Dresser-Rand India Pvt. Ltd. (supra) rendered by the Mumbai Bench of the Tribunal, the restriction placed by the TPO in providing the working capital adjustment was not justified. The AO/TPO is directed to allow the actual adjustment towards the differences in the working capital position between the assessee and the entrepreneurial companies selected as comparable.
The next ground of appeal is with respect to disallowance of software expenses. The facts with regard to this issue are that the assessee has incurred expenses towards purchase of application software (i.e. obtaining or renewing the licenses for use of certain application software) and has deducted tax at source in respect of such payment towards application software. According to the assessee, the incurrence of such expenditure is necessary to carry on the business activities more effectively and efficiently leaving the capital base untouched. The said expenditure being revenue in nature has been charged off in the year in which it was incurred i.e. FY 2008-09. The breakup of software expenses is as under:-
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License fees: The assessee company has paid an amount of Rs.
1,766,184 to Moog IFSC [Moog Ireland International Financial Service Centre] towards license usage charges. Moog IFSC had purchased
MFGpro software licenses from QAD Inc. MFGpro is an application software designed to perform and manage business processes such as
finances, manufacturing, supply chain management etc. By incurring the said expenses, the assessee company had acquired only the license to use
the software and there was no outright purchase of software giving
ownership to the company of the said software. The copy of agreement with Moog IFSC has been submitted in the paperbook at Page Nos. 102 -
103.
Further, an amount of Rs. 5,225,810 has been paid to various vendors to obtain license which is used by the assessee in its day to day
running of the business and, according to the assessee, it neither provides any enduring benefit to the assessee company nor brings into existence
any asset to provide enduring benefit.
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EPR Maintenance and IT allocation charges: The assessee company has paid an amount of Rs. 1,333,427 towards maintenance of
MFGpro software licenses as per clause 9 of the aforesaid agreement between Moog IFSC and the assessee. Further, the assessee had
incurred an amount of Rs. 3,626,423 as IT allocation charges which was
paid to assessee’s parent company, Moog Inc. Moog Inc. has entered into a global contract for usage of certain Information Technology services,
which is to be used in the daily business operation of group companies of Moog Inc. globally.
In the present case, Moog Inc. has cross-charged the amount of Rs.
3,626,423 to the assessee as its share of IT usage charges. These expenses being IT usage charges are recurring in nature and required to
be paid every year depending on the yearly usage of IT system. The Company does not acquire any right or ownership in any of the assets
upon payment of such allocation charges.
The AO has disallowed the above software expenditure on the ground that the same is capital in nature and hence provided depreciation
on the same at a rate of 30% (Assuming that the software has been put to use for less than 180 days).
Before us, it was submitted that In this regard, the entire software
expenditure amounting to Rs. 11,951,844 is allowable as deduction under section 37(1) of the Act on the following grounds:-
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a. The above referred expenditure has been incurred on obtaining or renewing the licenses for use, of certain application software and as this expenditure was incurred with the prime objective of carrying on the business activities more effectively and profitably leaving the capital base untouched. b. The test of enduring benefit is more prone to failure in the case of computer software where the pace of advancement is so rapid that whatever technology is installed today becomes obsolete within a short time. c. No portion of the application software was custom made software and all of them had been purchased “off the shelf”. Further, the assessee was merely a licensee and the right to use the software was subject to the conditions mentioned in the license agreement. d. Software acquired under a license on terms and conditions whereby ownership is retained by the licensor and where such software only adds to the efficient running of day to day operation of business, cannot be held to be expenditure of capital nature as they were only copyrighted articles. All rights, title and interest in or to the programs or documentation, modifications, enhancements and derivatives shall at all times remain the property of or vest on the licensor. Thus the “ownership test” of the software is not satisfied which is an essential condition to capitalize and claim depreciation under the Act. e. Further, every advantage of enduring nature acquired by an assessee may not bring a capital asset into existence. As held by the Hon’ble Supreme Court in the case of Empire Jute Ltd. (124 ITR 1), what is material to consider is the nature of the advantage in a commercial sense. If the advantage consists merely in facilitating the assessee’s business operations or enabling the management and conduct of the assessee’s business more efficiently or more profitably while leaving the fixed capital untouched, the expenditure would be on revenue account, even though the advantage may endure for an indefinite future.
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f. The application software has limited life unlike system software, which is used as tools of business. It is like any component or consumable item or spare part in a plant and machinery. By using such software, merely the efficiency is enhanced but by itself no capital asset is brought into existence.
The ld. counsel for the assessee further submitted that the provisions of the Act do not provide for a definition of “Capital expenditure” and “Revenue expenditure”. Accordingly, the principles laid down by the Courts in numerous decisions would have to be looked into to determine whether the expenditure is a capital or revenue expenditure. In general, there is no particular rule to determine whether a particular expenditure is capital expenditure or revenue expenditure. The same would have to be determined based on the facts and circumstances of each particular case.
It was also submitted that as per section 37(1) of the Act, “Any expenditure (not being in the nature described in section 30 to 36 and not being in the nature of capital expenditure or personal expenses of the assessee), laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing income chargeable under the head “profits and gains from business or profession”.
Thus for an expenditure to be deductible in terms of section 37(1) of the Act, the following conditions are to be satisfied —
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a. The expenditure should not be of the nature described in sections 30 to 36 of the Act; b. It should not be in the nature of personal expenses; c. It should have been laid out or expended wholly and exclusively for the purpose of the business; and d. It should not be in the nature of capital expenditure.
The ld. counsel for the assessee submitted that in the instant case, all the above conditions are satisfied and thus the application software expenditure including maintenance expenses is revenue in nature and is eligible for deduction under section 37(1) of the Act. Attention was invited to the fact that the assessee has only acquired the requisite licenses to use the application software and hence the ownership and the intellectual properties of the software continue to remain with the licensor.
Reliance was placed on the decision of the Special Bench Delhi in the case of Amway India Enterprises v. DCIT, 301 ITR 1 (AT)(Del)(SB), wherein certain tests had been laid down for ascertaining whether the expenditure on purchase of software is to be treated as revenue or capital. The below tests are cumulative and not mutually exclusive. In case the transaction of purchase of software satisfies all the tests mentioned below, it will be considered as a capital expenditure.
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The ld. counsel for the assessee submitted that in the instant case, the assessee is not satisfying all the tests set out by the Special Bench in the case cited supra and therefore the software expense should be treated as revenue in nature. Reliance was also placed on the following decisions:-
- Lubrizol India Ltd. 37 taxmann.com 294 (Bom) - N.J. India Invest (P) Ltd. 32 taxmann.com 367 (Guj) - Oracle India (P) Ltd., 39 taxmann.com 150 (Del) - Raychem RPG Ltd. 21 taxmann.com 507 (Bom) - CIT v. Varinder Agro Chemicals Ltd. 309 ITR 272 (P&H) - CIT v. Asahi India Safety Glass Ltd. v. CIT, 15 taxmann.com 382 (Del) - CIT v. J.K. Synthetic Ltd., 2008-TIOL-671-DEL - O.K. Play India Ltd. 346 ITR 57 (P&H) - IBM India Ltd. v. CIT, ITA No.755/Bang/2003. - Meritor Light Vehicle Systems India Pvt. Ltd., ITA No.140/Bang/2011. - Danfoss Industries (P) Ltd., 37 taxmann.com 240, ITAT Chennai. - Amway India Enterprises, 111 ITD 112 (SB) (Del) - Glaxo Smith Kline Consumer Healthcare Ltd. v. ACIT, 112 TTJ 94, ITAT, Chd.
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- Sharp Business Systems (I) Ltd. v. DCIT, 59 DTR 385, ITAT Del.
- Business Information Processing Services v. ACIT, 239 ITR S-19, ITAT Jaipur. - CIT v. G.E. Capital Services Ltd., ITA No.560/Del/2007.
We find that In the present case, the license fee paid represents usage charges of leased licenses. Further, the use of license does not give any ownership of the software to the assessee and thereby does not lead to creation of any capital asset. The license used by the assessee is application software designed to perform various business processes. The application software enables the assessee to carry out its business operations efficiently and smoothly and does not provide any enduring benefit. Such software enhances the efficiency of the operations. It is an aid in the manufacturing process. Considering the above facts and the judicial precedents relied upon by the assessee company, we hold that the said license fees and maintenance fees is to be allowed as revenue expenditure.
Since we have allowed the assessee’s claim of software expenditure to be treated as revenue expenditure, the alternate ground for non-grant of additional deduction u/s. 10B on account of capitalisation of software expenditure is not considered for adjudication.
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In the result, the appeal by the assessee is partly allowed for statistical purposes.
Pronounced in the open court on this 27th day of November, 2015. 46.
Sd/- `Sd/-
( ABRAHAM P. GEORGE ) (ASHA VIJAYARAGHAVAN ) Accountant Member Judicial Member
Bangalore, Dated, the 27th November, 2015.
/D S/
Copy to:
Appellant 2. Respondent 3. CIT 4. CIT(A) 5. DR, ITAT, Bangalore. 6. Guard file
By order
Assistant Registrar, ITAT, Bangalore.