CLR Editorial Notes: The Tribunal had to consider the following important transfer pricing issues:
(i) whether a one-time and extraordinary item of expenditure (ESOP cost) debited to the assessee™s P&L A/c has to be excluded while comparing the margins,
(ii) whether for the purpose of comparison of margins, the consolidated results of comparables having profit from different overseas markets can be considered?
(iii) whether extreme profit and loss cases should be excluded or in case extreme profit cases are included, the case of losses should also be included?
(iv) whether a turnover filter can be adopted to exclude companies with extremely high turnover? (v) whether the assessee can seek to exclude its own comparables?
(vi) whether an adjustment for working capital is permissible?
(vii) whether if the assessee can show that because the AE is in a high tax jurisdiction and that there is no transfer of profit to a low tax jurisdiction, a transfer pricing adjustment need not be made?
The Tribunal Held:
(i) A comparison of margin between the assessee and the comparables has to be made under identical conditions. As the comparables had not claimed any extraordinary item of expenditure on account of ESOP cost, for the purpose of making proper comparison of the margin, onetime ESOP cost incurred by the assessee has to be excluded. There is nothing in the Rules that prohibits adjustment in the margin of the assessee to remove impact of any extraordinary factors (Skoda 30 SOT 319 (Pune), Demag Cranes 49 SOT 610 (Pune), Transwitch, Toyota Kirloskar Motors followed);
(ii) Under Rule 10B(2)(d), the comparability of transactions has to be considered after taking into account the prevailing market conditions including geographical locations, size of market and cost of capital and labour etc. Therefore, consolidated results which include profit from different overseas jurisdictions having different geographical and marketing conditions will not be comparable. Only standalone results should be adopted for the purpose of comparison of margins (American Express followed);
(iii) Comparable cases cannot be rejected only on the ground of extremely high profit or loss. In case the companies satisfy the comparability criteria, and do not involve any abnormal business conditions, the same cannot be rejected only on the ground of loss or high profit. The OECD guidelines also provide that loss making uncontrolled transactions should be further investigated and it should be rejected only when the loss does not reflect the normal business conditions;
(iva) In certain Tribunal decisions, various reasons have been given for applying the turnover filter for comparison of margins such as economy of scale, greater bargaining power, more skilled employees and higher risk taking capabilities in cases of high turnover companies, which increase the margins with rise in turnover. However, in these decisions, no detailed examination has been made as to how these factors increase the profitability with rising turnover. The concept of economy of scale is relevant to manufacturing concerns, which have high fixed assets and, therefore, with the rise in volume, cost per unit of the product decreases, which is the reason of increase in margin as scale of operations goes up because with the same fixed cost there is more output when the turnover is high. The same is not true in case of service companies, which do not require high fixed assets. In these cases employees are the main assets, who in the case of the assessee are software engineers, who are recruited from project to project depending upon the requirement. The revenue in these cases is directly related to manpower utilized. With rise in volume cost goes up proportionately. Therefore, the concept of economy of scale cannot be applied to service oriented companies. On facts, it is shown by the department that in the case of the comparables selected by the assessee, there is no linear relationship between margin and turnover and that that the margin has come down with the rise in turnover in some cases. Such detailed study was not available before the various Benches of the Tribunal which have applied the turnover filter and consequently those decisions cannot be followed;
(ivb) Under Rule 10B(2), comparability of international transactions with uncontrolled transactions has to be judged with reference to functions performed, asset employed and risk assumed. The functions performed by all comparable companies are same as it is because of same functions they have been selected by the assessee as comparables. The asset employed has two dimensions i.e. quantity and quality. More employees would mean more turnover but there is no linear relationship between margin and turnover. As regards quality of employees, this will depend upon the nature of projects and since the comparables are operating in the same field having similar nature of work, and employee cost being more in case of more skilled manpower, it will not have much impact on the margins. As for the bargaining power, the assessee is part of a multinational group and well established in the field and, therefore, it can not be accepted that it has less bargaining power than any of the Indian Companies, however big it may be. Therefore, it would not be appropriate to apply turnover filter for the purpose of comparison of margins. However, for the purpose of comparison, the turnover would be relevant only from the limited purpose to ensure that the comparable selected is an established player capable of executing all types of work relating to software development as the assessee is also an established company in the field (Genesis Integrating System not followed);
(v) The assessee had selected Infosys and Wipro as comparables on the basis of its own transfer pricing study after being fully aware of its work profile. The assessee raised no plea either before the TPO or DRP for excluding these comparables though it had added some more comparables. The assessee, therefore, cannot raise any grievance before the Tribunal to exclude these comparables, without giving any cogent and convincing reason. The reasons given by the assessee (turnover filter) are not found convincing and so it cannot be permitted to exclude Infosys and Wipro (Kansai Nerolac Paint followed)
(vi) Working capital adjustments are required to be made because these do impact the profitability of the company. Rule 10B(2)(d) also provides that the comparability has to be judged with respect to various factors including the market conditions, geographical conditions, cost of labour and capital in the market. Accounts receivable/payable effect the cost of working capital. A company which has a substantial amount blocked with the debtors for a long period cannot be fully comparable to the case which is able to recover the debt promptly. The average of opening and closing balance in the account receivable/payable for the relevant year may be adopted which may broadly give the representative level of working capital over the year. Even if there is some difference with respect to the representative level, it will not effect the comparability as the same method will be applied to all cases. Working capital adjustment can not be denied to the assessee only on the ground that the assessee had not made any claim in the TP study if it is possible to make such adjustment. Working capital adjustment will improve the comparability.
(vii) The argument that no adjustment need be made because the parent company is situated in US where tax rate is high and that there was no reason for the assessee to transfer profit to the parent company is not acceptable. The arm™s length price of an international transaction has to be calculated with respect to similar transaction with an unrelated party as per the method prescribed and the revenue is not required to prove tax avoidance due to transfer of profit to lower tax jurisdiction. Arguments such as that the parent company was incurring loss or had shown lower margin are not relevant (Aztek Software 107 ITD 141 (SB) & 24/7 Customers.com followed)
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