Transfer Pricing: Loss-making & Super-Profit companies are not comparable

Sapient Corporation Pvt Ltd vs. DCIT (ITAT Delhi)

Brief History of the Case:-

The assessee is a subsidiary company of M/s Sapient Corporation, USA and was set up under the Software Technology  Park  Scheme of the Government of India. The assessee renders customized software development services to associated enterprises and also renders post sales support services. The assessee in the relevant assessment previous year has entered into international transactions with associated enterprises. The assessee determined the arms™ length price of the international transactions of software development and related services by applying TNMM as most appropriate method. The assessee had benchmarked its international transactions with 10 comparable companies with an average operating profit ratio (OP/TC) of 9.31%. Since the (OP/TC) earned by the assessee on transactions with the associated enterprise at 12.49% was higher than that of 10 comparable companies and development services was considered to be at arms™ length price.  The TPO & DRP rejected a few comparables on the ground that they were loss-making and recomputed the OP/OC of the other comparables at a higher rate. Before the Tribunal, the assessee claimed that if loss making companies were excluded, a super profit earning company should also be removed from the comparables. The appeal filed by assessee is allowed.

The full judgement is as follows:-

IN THE INCOME TAX APPELLATE TRIBUNAL

DELHI BENCH E NEW DELHI

BEFORE SHRI RAJPAL YADAV, JUDICIAL MEMBER

AND SHRI SHAMIM YAHYA, ACCOUNTANT MEMBER

I.T.A. No. 5263/Del/2010A.Y. : 2006-07

Sapient Corporation Pvt. Ltd.,

C/o Pankaj Vasani,

Sapient Tower, DLF Cyber Greens

,DLF, Phase-III, Sector-25A,

Gurgaon 122 022

-vs-

Dy. Commissioner of Income Tax,

Circle 7(1),New Delhi

(PAN : AAECS6286M)

ORDER

PER SHAMIM YAHYA: AM

This appeal by the assessee is directed against the order of theAssessing Officer dated 12.10.2010 and pertains to assessment year2006-07.

2. The first issue raised is that Assessing Officer has erred inmaking addition of ` 14,79,00,000/- on account alleged difference inarms™ length price of the international transactions of softwaredevelopment services on the basis of the order passed u/s 92CA(3) ofthe Act by the Transfer Pricing Officer.

3. The assessee in this case is a subsidiary of M/s SapientCorporation, USA. The company was incorporated on March, 9, 2000 and was set up under the Software Technology Park Scheme of the Government of India. The assessee renders customized softwaredevelopment services to associated enterprises and also renders postsales support services. The assessee in the relevant assessment previous year has entered into international transactions withassociated enterprises. In the Transfer Pricing documentation theassessee determined the arms™ length price of the internationaltransactions of software development and related services by applyingTNMM as most appropriate method. The assessee had benchmarkedits international transactions with 10 comparable companies with anaverage operating profit ratio (OP/TC) of 9.31%.

3.1 The final list of comparable companies is as under:-

S.No.                          Name of the company                               FY                                 OP/TC

1.                                       Birlasoft Ltd.                                      200503                              0.06%

2.                                     Datamatics Ltd.                                 200409                                6.09%

3.                             Goldstone TechnologiesLtd.                200503                               1.50%

4.                       Maaars SoftwareInternational Ltd.        200603                                3.18%

5.                       Melstar InfotechInternational ltd.         200503                                9.17%

6.                       Prithvi InformationSolutions Ltd.          200603                              12.48%

7.                                 Quintegra Solutions Ltd.                    200603                             13.51%

8.                                 RS Software India Ltd.                        200603                              15.29%

9.                            Visualsoft Technologies Ltd.                200503                              15.99%

10.                                     Zenith Infotech Ltd.                     200603                               49.47%

Mean                                                                                                9.31%

The operating profit margin (OP/OC) of the assessee was computed at12.49%.Since the (OP/TC) earned by the assessee on transactions with the associated enterprise at 12.49% was higher than the average operating profit margin earned on similar transactions with unrelated third parties at 9.31% the international transaction of provision ofsoftware design and development services was considered to be at arms™ length price.The TPO in the course of the Transfer Pricing assessment proceedings required the assessee to submit current year data of all comparablecompanies considered in transfer pricing study report. Since at that time, financials of Datamatics Limited was not available, the appellant submitted current year operating results of the remaining 9 companieswith an OP/TC ratio of 12.05% as follows:-

S.No.                          Name of the company                               FY                                 OP/TC

1.                                       Birlasoft Ltd.                                      200503                              -2.59%

2.                             Goldstone TechnologiesLtd.                200603                                0.95%

3.                       Maaars SoftwareInternational Ltd.        200603                                 4.50%

4.                       Melstar InfotechInternational ltd.         200503                                1.79%

5.                       Prithvi InformationSolutions Ltd.          200603                              12.65%

6.                                 Quintegra Solutions Ltd.                    200603                             13.71%

7.                                 RS Software India Ltd.                        200603                              15.10%

8.                            Visualsoft Technologies Ltd.                200603                              12.67%

9.                                     Zenith Infotech Ltd.                     200603                               49.73%

Mean                                                                                            12.05%

The TPO in his transfer pricing order has further rejected 5comparable companies identified by the assessee on the following ground:

S.No.                Name of company                                      Reasons for rejection

1.                                Birlasoft Ltd.                                      Decreasing profitabilitytrend and sales since 3years.

2.                 Goldstone Technologies Ltd.                     Decreasing profitabilitytrend and sales since 3years.

3.                 Maars Software International Ltd.          Not comparable as wages tocost ratio only 0.24%                                                                                                                  asagainst 65% of theassessee.

4.              Melstar InformationTechnologies Ltd.     Segmental data notavailable, FOREX earringonly                                                                                                                      30%.

5.                    RS Software (India) Ltd.                              Negative net worth

The TPO benchmarked the operating profit margin (OP/TC%) of the appellant company with the margin of the following 4 high profit making companies:

S.No.                     Name of the company                                  FY                                   OP/TC

1.                       Prithvi InformationSolutions Ltd.          200603                              12.65%

2.                            Visualsoft Technologies Ltd.                200603                              12.67%

3.                                        Zenith Infotech Ltd.                     200603                              49.73%

4.                                      Quintegra Solutions Ltd.              200603                               13.71%

Arithmetic Mean                                                                           22.19%

Accordingly, the Transfer Pricing Officer in the order passed under section 92CA(3) of the Act computed an adjustment of ` 14,79,00,000/- on account of the difference in the margin of the comparable companies and the appellant company.

4. Against the above order, the assessee is in appeal before us.

5. Assessee™s submissions in this regard are summarized as under:-

(i) The TPO has considered Zenith Infotech even though whenit earning supernormal profits and does not satisfy his ownadditional filters:Zenith Infotech has remarked an abnormal high profit margin of 49.73% during the financial year 2005-06 and there has been sharp increase in profitability and sales. TheOP/TC during the year is summarized as follows:-

Year                               Mar -04                      Mar-05                   Mar-06               Mar-07

Sales in crores              18.28                          21.90                      35.37                 66.97%

sales in increaseover

base year Mar 04                                               120%                         193%                  366%

OP/TC                              3.10%                        22.27%                      49.73%              87.88%%

margins increase                                                 719%                         1605%                2835%

Over base year Mar 04

It may be pointed out that Zenith Infotech is pre-dominantly software product company, while the appellant is engaged in rendering softwaredevelopment services. It is a matter of common knowledge that a software product company ends up earning higher margin as they areengaged in selling software products owned by them. The aforesaid is also corroborated from the facts that wages to cost ratio of Zenith Infotech is only 37.5% (which is usual case in the case of softwareproduct company) as opposed to 65% in the case of the appellant a software service company. (refer page 852-855 of the supplementary paper book for brief product profile of Zenith taken from the website www.zenithinfotech.com)

The DRP rejected the contention of the appellant of excluding theabove company from the set of comparable companies on the groundthat the said company was included in the list of comparable companies in the transfer pricing report.

Reliance in this regard is placed on the ruling of the Hon’bleChandigarh ITA T, [ Special Bench in the case of  Quark Systems Private Limited v. DCIT: 2010 38 SOT 307 while reviewing the comparability analysis of  super profit compal1les provides as under:

” ….. Even if the taxpayer or its counsel had taken Datamatics ascomparable in its IP audit, the taxpayer is entitled to point out tothe Tribunal that above enterprise has wrongly been taken ascomparable. In fact there are vast differences between testedparty and Datamatics. The case of Datamatics is like that ofImercius Technologies” representing extreme positions. IfImercious Technologies has suffered heavy losses and, therefore,it is not treated as a comparable by the tax authorities, they alsohave to consider that Datamatics has earned extraordinary profitand has a huge turnover. (emphasis supplied)

Reliance in this regard is also placed on the following decisionswherein a super profit margin company has been directed to beexcluded:Adobe Systems India (P) Ltd. v. ACIT: LT.A. No. 5043/De1/2010Mentor Graphics (Noida) Pvt. Ltd : 109 ITD 101E-Gain Communication Pvt. Ltd. v. DCIT: 118 ITD 243Philips Software Centre (P) Ltd. v. ACIT: 119TTJ721ITO v. Sunay Jewels Pvt. Ltd: ITA No. 5758/Mum/2007

Further, Zenith Infotech cannot be taken as comparable also for thereason that, (i) the wages to cost ratio of Zenith Infotech is 37.50% asagainst the wage to cost ratio of the applicant at 65% and (ii) for ex earning of said company is _only 39% of the total revenue. It may benoted that the TPO has himself had rejected Melstar InformationTechnologies, inter alia, on the basis of low forex earnings without applying the same selection criteria while considering Zenith InfotechLtd. as comparable company.

Computation of margin of comparable after eliminating Zenith Infotech

The average of operating profit over cost of the remaining threecompanies after eliminating Zenith Infotech Software is as follows:

S. No.            Name of the company                               FY                                         OP/TC

1.                Prithvi Information Solutions Ltd              200603                                12.65%

2.                       Visualsoft Technologies Ltd.                  200603                               12.67%

3.                            Quintegra Solutions Ltd.                     200603                                13.71%

Arithmetic Mean                                                                                   13.01 %

Since the OP/TC of the appellant at 12.49% is within the safe harborrange of (+/-)5% as per the proviso to section 92C(2) of OP/TC marginof 3 comparable companies at 13.01%, no adjustment is warranted on account of difference in arm’s length price of the internationaltransaction.

(ii) Rejection on the basis of additional filtersIn addition to the filter of wages/cost ratio, the TPO in his order hasapplied the following additional filters:

a. Forex earning

b. Declining operating results and sales

c. Negative networth

It is submitted that that the additional filters have been used by theTPO to suit his requirement and to arrive at predetermined results. Itwould be appreciated that rejection of the companies on the basis ofthe profit margin, rather than functional or asset profile, would notmeet the comparability standard required in application of the “TNMM’method, which is selected by the appellant as the most appropriatemethod for benchmarking. It is a settled position that under thetransfer pricing regulation, the comparability is to be judged withreference to functions performed, assets utilized and risk assumed(FAR) and the aforesaid functions parameters such as decliningoperating results and sales, etc., are not the relevant consideration.

Reliance in this regard is placed on the following decisions:

a. Mentor Graphics (Noida) Private Limited: 109 ITD 101

b. E-Gain Communication Pvt. Ltd. 118 ITD 234

c. Aztec Software India Pvt. Limited: 107 ITD 141

d. Sony India Pvt. Limited: 114 ITD 448

e. Philips Software: 26 SOT 226

f. Quark Systems Pvt. Limited v. DCIT: ITA NO.1 00 & 115/CHD/2009

g. DCIT vs Indo American Jewellery Ltd.: 131 TTJ 163 ‘

6. Alternatively the assessee had made fresh data base to identifycomparables companies. According to which the average PLI is12.60%. Assessee has claimed that since the operating profit ratio ofthe assessee at 12.49% is within the safe harbor of (+/-) 5% providedin section 92(2) of the Act with respect to the average of operatingprofit margin of the above comparable companies, i.e. 12.49%, the international transaction entered into by the assessee with associatedenterprises, are, therefore, considered being at arms length price onthe applying TNMM. The DRP however, did not deal with the aforesaidfresh set of comparable placed on record by the assessee.

7, Ld. Departmental Representative on the other hand hassubmitted that Zenith Infotech was chosen by assessee itself in the listof comparables. Hence, the assessee cannot agitate against itsinclusion. The Ld. Departmental Representative further claimed thatassessee has raised perfunctory objection before the authorities belowregarding exclusion of Zenith Infotech in the comparable. Hence thematter was not dealt with in detail by the TPO or the DRP. In therejoinder, ld. counsel of the assessee has submitted that all thenecessary documentation in this regard were before the TPO and theDRP. Ld. counsel of the claimed that if loss making companies weretaken out by the TPO from the comparables, Zenith Infotech Ltd.which had shown super normal profits should also be excluded. Ld.counsel of the assessee further claimed that there is no estoppelsagainst the assessee. Now assessee has claimed that Zenith Infotechis not comparable. Ld. counsel further claimed that there cannot beany motive to the assessee as the entire income is exempt u/s 10A.

8. We have heard the rival contentions in light of the materialproduced and precedents relied upon. We find that TPO in his order has rejected the five comparables companies identified by the assessee. the TPO benchmarked the operating profit margin by theassessee company with four profit making companies, whichexcluded Zenith Infotech Ltd. The margin of these companies are as under:-

S.No.                           Name of the company                            FY                               OP/TC

1.                       Prithvi InformationSolutions Ltd.           200603                       12.65%

2.                               Visualsoft Technologies Ltd.              200603                       12.67%

3.                                              Zenith Infotech Ltd.               200603                        49.73%

4.                                       Quintegra Solutions Ltd.             200603                          13.71%

Arithmetic Mean                                                                       22.19%

8.1 Now it is the contention of the assessee that when loss makingcompanies were taken out from the comparables by the TPO, the superprofit earning company, Zenith Infotech Ltd. should also be removed from the comparables. Ld. counsel of the assessee further claimedthat this company does not satisfy TPO™s own additional filters. Ithas been submitted that Zenith Infotech Ltd. has shown abnormal high profit margin. It has been submitted that Zenith Infotech Ltd. ispredominantly software product company, while the assessee isengaged in rendering software development services. It has been submitted that software product company ends up earning highermargin as they are engaged in the selling of software products ownedby them. Upon careful consideration, we find ourselves in agreement with the assessee™s contention that when the loss making companies  have been taken out from the list of comparables by the TPO, ZenithInfotech Ltd. which showed super profits should also be excluded. Thefact that assessee has himself included in the list of comparables,initially cannot act of estoppel particularly in light of the fact thatAssessing Officer has only chosen the companies which are showingprofits and has rejected the other companies which showed loss. Inthis regard reliance can be placed upon ITAT Special Bench decisionin the case of Quark System vs. DCIT (2010) 38 SOT 307, whichsupports assessee contention of removal of Zenith Infotech fromcomparables, as it showed super profits. Furthermore, it is noted thatZenith Infotech is predominately software product company, while theassessee is engaged in rendering software development services. It isfound that software product company shows higher margin. This isalso corroborated by the fact that wages to cost ratio of Zenith Infotech is only 37.5% as opposed to 65% of assessee company.Hence, we are of the considered opinion that when loss makingcompanies have been removed from comparables by the TPO,assessee is right in contending that Zenith Infotech should also beremoved as it showed super profits. As submitted in the chart inpreceding paragraph the average of operating profit over cost of theremaining three companies after eliminating Zenith Infotech Softwareis as follows:

S. No.                         Name of the company                                 FY                          OP/TC

1.                          Prithvi Information Solutions                     200603                              12.65%

2.                                Visualsoft Technologies Ltd.                 200603                             12.67%

3.                                    Quintegra Solutions Ltd.                        200603                            13.71%

Arithmetic Mean                                                                   13.01%

 

Since the OP/TC of the appellant at 12.49% is within the safe harborrange of (+/-)5% as per the proviso to section 92C(2) of OP/TC marginof 3 comparable companies at 13.01%, no adjustment is warranted onaccount of difference in arm’s length price of the internationaltransaction.

8.2 The contention of the Ld. Departmental Representative thatassessee has not vigorously agitated the issue of inclusion of ZenithInfotech before the authorities below is not acceptable, as all thenecessary documents for assessee™s contention in this regard werebefore the authorities below.

8.3 In the background of the aforesaid discussion, we delete theaddition made by the Assessing Officer with regard to arms™ lengthprice.

9. The next issue raised is that Assessing Officer has erred inmaking disallowance of 1,18,31,549/- out of expenditure onadvertisement and sale promotion and recruitment and training expenses. aggregating to ` 1,57,75,411/- holding that such expenseswere incurred for better sales and turnover and contribution to theprofits of the business and hence benefit of which expenditure accruedto the assessee over the years.

10. On this issue the Assessing Officer noted that as per the profitand loss account the assessee company has claimed expenditure of `1,29,25,617/- on account of recruitment and training expenditure and `28,49,794/- on account of advertisement and sales promotionexpenses.

11. Assessing Officer was of the opinion that these expenditures hasgiven the assessee benefit spread over a certain number of years. Inthis regard, assessee has contended that Income Tax Law does notprovide ˜concept of deferred revenue expenditure™. Assessing Officerdid not accept this proposition and he held that the above saidexpenditure leads to an enduring benefit to the assessee company.Accordingly, only 25% of the expenditure of ` 39,43,852/- was allowedand the balance amount of ` 1,18,31,559/- was disallowed and addedto the total income of the assessee company.

12. Against the above order the assessee is in appeal before us.

13. Assessee has submitted that the aforesaid expenditures areincurred on revenue account and did not result in any enduring benefitin the capital field. Further, there is no concept of deferred revenueexpenditure under the Income Tax Act and expenses are to be alloweddeduction in full in the order in which they are incurred. In thisregard, assessee placed reliance of catena of case laws. It hasfurther been submitted that the Ld. Commissioner of Income Tax(Appeals) in assessee case for A.Y. 04-05 vide order dated 8.11.2007,deleted the similar disallowance made by the Assessing Officer in thatyear. It has been claimed that department has accepted the findingsof the Ld. Commissioner of Income Tax (Appeals) with respect todisallowance of recruitment and training expenses and advertisementexpenses and did not appeal to the Tribunal on this account.

14. Ld. Departmental Representative relied upon the orders of theAssessing Officer .

15. We have heard the rival contentions in light of the materialproduced and precedents relied upon. We find that it is not the case   here that the expenses are bogus and not incurred. It has also not thecase that the entire expenses falls under the realm of capitalexpenses. The Assessing Officer is of the opinion that only 25% ofthe expenditure should be allowed during the year and the rest has tobe added to the income of the assessee. We find ourselves inagreement with the contention of the ld. counsel of the assessee thatthere is no concept of deferred revenue expenditure under the IT law.The expenditure of account of recruitment and training expenses andadvertisement and sales promotion expenses cannot be said to becapital expenditure. Under these circumstances, Assessing Officer™saction in this regard is not sustainable. Moreover, we note thatsimilar disallowance were deleted by the Ld. Commissioner of IncomeTax (Appeals) in the assessment year 2004-05 against which thedepartment did not file appeal before the Tribunal.

16. In the background of the aforesaid discussion and precedent, wedelete the disallowance made in this regard.

17. In the result, the appeal filed by the assessee is allowed.Order pronounced in the open court on 06/05/2011.

Sd/-

[RAJPAL YADAV]

[SHAMIM YAHYA]

JUDICIAL

MEMBER ACCOUNTAN

T MEMBER

Date 06/05/2011SRB

Tags: ITATtransfer pricing

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