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Losses of non Section 10A units cannot be set off against profit of 10A unit

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IN THE ITAT BANGALORE BENCH ‘A’

GE India Technology Centre (P.) Ltd.

versus

Deputy Director of Income-tax

IT APPEAL NOs. 789 (BANG.) OF 2010 and 487 & 925 (Bang.) of 2011

[Assessment years 2004-05 to 2006-07]

DECEMBER 31, 2012

ORDER

P Madhavi Devi, Judicial Member

These appeals are filed by the assessee. The relevant assessment years are 2004-05, 2005-06 and 2006-07. The appeals for the assessment years 2004-05, 2005-06 are directed against the order of the Commissioner of Income-tax – (Appeals) – IV at Bangalore dated 30.03.2010, while appeal for the assessment year 2006-07 is against the order of the Assessing Officer passed in accordance with the order of the DRP. The appeals arise out of the assessments completed u/s 143(3) of the Income-tax Act, 1961.

2. As the issues involved in all the three appeals are common, the appeals were heard together and are disposed of by this common and consolidated order.

3. For the assessment year, 2004-05, grounds No.1 to 7 are against

(a)  the reference made by the AO to the Transfer Pricing Officer (TPO) u/s 92CA of the Income-tax Act for the determination of the ALP by rejecting the TP study made by the assessee;

(b)  the order of the TPO holding the assessee to be a Service Provider, working on Research and Development and not Software Development as claimed by the assessee; and

(c)  rejecting the assessee’s comparables and conducting his own study and selection of comparables.

4. For the assessment year 2005-06, grounds No.1 and 2 are also against the rejection of TP study conducted by the assessee and upholding the transfer price study conducted by the Transfer Pricing Officer.

5. For the assessment year 2006-07, the grounds of appeal Nos1 and 2 are against the order of the DRP in upholding the draft assessment order in spite of it being passed -

(1)  in violation of principles of natural justice;

(2)  not fulfilling the conditions for making a reference u/s 92CA of the Income-tax Act; and

(3)  failing to demonstrate that the assessee’s motive was to shift the profit outside India and in upholding the TPO’s order in making the TP adjustment.

6. At the time of hearing, the learned counsel for the assessee, in addition to the oral arguments advanced, has also filed written submissions stating that the grounds No.1 and 2 for the assessment year 2006-07 and grounds No.1 to 7 for the assessment year 2004- 05 and grounds Nos.1 and 2 for the assessment year 2005-06 are general grounds and, therefore, are not being dealt with. Further, we find that issues/grounds raised by the assessee in these grounds are covered by the decision of Special Bench of the Tribunal in the case of M/s Aztech Software & Technology Services Ltd., which has been confirmed by the Jurisdictional High Court in ITA Nos.826 & 827/2007 dated 10th July, 2012 and, therefore, these grounds are not adjudicated.

7. The common grievance in all the three years is against the finding of the TPO that the activities of the assessee in the international transactions are in the nature of ‘Service Provider’ working for ‘Research and Development’ and not ‘Software Development’ as claimed by the assessee. We shall deal with this issue first.

8. According to the assessee, it has entered into international transactions with its associated enterprises for export of customized electronic data, computer software and any other tangible articles or things as a result of research activity. Therefore, the assessee while conducting its TP study has adopted/chosen the comparables which are all in the field of ‘development and export of computer software’. The Assessing Officer made a reference to the transfer pricing officer u/s 92CA of the Act for determination of the ALP (Arms Length Price). During the proceedings u/s 92CA of the Income-tax Act, the TPO observed that the assessee is providing contract services of research and development and other services in various fields of engineering. As per the service agreement dated 13.6.2001, assessee has to provide the following services to the party making such request.

  •  Identifying business opportunities and carry out research and development/other services in the following services : -

(a)  Chemistry and Catalysis

(b)  Chemical Engineering and Mathematical Modeling

(c)  Engineering Mechanics

 (d)  Electronics Systems

 (e)  Industrial Electronics

 (f)  Information Technology & E-Commerce

 (g)  Metallurgy & Ceramics

 (h)  Manufacturing & Business Process

 (i)  Mechanical Systems

 (j)  Polymer and other material sciences

 (k)  Or any other areas mutually agreed.

9. As per the services agreement dated 1.12.2003, it has to provide the following services to the party making such request -

  •  Identify business opportunities for overseas customers business (of AE) for sourcing research & development/other services from GEITC (the assessee) in the following areas -

 (a)  Controls & Software

 (b)  Propulsion Rotating Equipment

 (c)  Tier II engine

 (d)  Diesel Engine COE

 (e)  Loco Modernization & Requisition Systems

 (f)  Drafting

 (g)  Cooling systems

 (h)  New Product Introduction

 (i)  Remote Monitoring & Diagnostics

 (j)  Cores Engineering

 (k)  E-Engg-Analysis

 (l)  Or any other areas to be mutually agreed.

10. From the perusal of above agreements, the TPO observed that the tax payer is doing the research and development activities and the end result is submitted through electronic media (via internet/networking) which is reported by the assessee as export of customized electronic data. The TPO, therefore, asked the assessee to furnish the details of FAR analysis in respect of each agreement with AEs. In reply to the same, the assessee filed a letter dated 29.9.2006 and made the following submission as regards the nature of activities carried on by the assessee, tax payer -

1.  GEITC is a private limited Company incorporated in June, 1999 in the State of Karnataka. GEITC is engaged in the business of exporting customized electronic data, computer software, articles or things generated from research activities using computer aided technology in several areas of technology to other GE companies outside India, and it is a captive R & D and engineering service provider to GE.

2.  All the research and software development activities are carried out at the John F.Welch Technology Centre (JFWTC) in various Laboratory/Development centers as under -

 (a)  Electronic System Laboratory

 (b)  Chemical Engineering & Modeling Center

 (c)  Manufacturing and Business Process Laboratory

 (d)  Information Technology Centre

 (e)  Electrical Systems & Technology Laboratory

 (f)  Industrial Engineering Laboratory

 (g)  Advanced Mechanical Engineering Laboratory

 3.  GEITC employs various qualified scientists and researchers and engineers to carry out research and software development activity in high impact technology areas such as Electromagnetic Analytics, Color Technology, Additive Technology etc.

 4.  The Scientists and Engineers engaged to carry out the said activity are equipped with highly advanced software development tools and also sophisticated equipments such as NMR, High End Analytical Equipment, High End IT Servers, HPC Nodes, Clean Room Equipment etc. The scientists and engineers employed by the company are highly qualified and company is having more than 600 PhDs and 1000 Masters, who are qualified in the various areas of High Impact Technology.

 5.  The kind of programs and projects that are provided by the overseas GE affiliate companies can be categorized as NPI (New Product Introduction) projects, products enhancement programs; productivity programs and RTS (Ready to Serve) programs. Inputs along with the clear deliverables are discussed before the beginning of the financial year and appropriate investments including software tools are committed.

 6.  The general process employed in carrying out the said research and engineering services using computer aided technology includes -

(a)  Study the existing product capabilities/engineering/chemical/manufacturing process; understand the requirement for enhanced features/improved processes and work on modeling using software tools and deliver the desired results in the form of revised engineering design/drawings, analysis reports in the form of customized electronic data;

(b)  Collect existing data for the above purpose of analysis and building engineering models using simulation techniques and high-end software tools;

(c)  Primary and detailed designing using computer aided design tools; and

(d)  Testing the design at the actual environment.

11. In order to verify the exact nature of assessee’s activities, the TPO also searched the web site of the tax payer and observed that the assessee is basically carrying out the research and development and engineering analysis with the aid of sophisticated labs/software in various fields of engineering. He, therefore, rejected the assessee’s TP study adopting the comparables who are in the filed of development of computer software holding that they are functionally different. He, therefore, proceeded to re-determine the ALP by conducting the search on the Database ‘prowess’ for fresh comparables. The search was made for business line ‘Technical Consultancy and engineering services and Research & Development’. Based on the said search, the TPO has short listed the following eight companies :-

(1)  Alphageo India Ltd.

(2)  Biotech Consortium India Ltd.

(3)  Clinigene International Pvt. Ltd.

(4)  Geologging Industries Ltd.

(5)  Lurgi India Co. Ltd.

(6)  Mahindra Acres Consulting Engineering Ltd.

(7)  Sunil Hitech Engineers Ltd.

(8)  Vimta Labs Ltd.

12. Out of these eight companies, the TPO rejected Biotech Consortium India Ltd., Clinigene International Pvt. Ltd., Geologging Industries Ltd., Mahindra Acres Consulting Engineering Ltd. and Sunil Hitech Engineers Ltd., on the ground that these companies have no forex earnings and hence are not catering to overseas market segment. He, therefore, accepted only the following three companies as comparables.

(1)  Alphageo India Ltd.

(2)  Lurgi India Co. Ltd.

(3)  Vimta Labs Ltd.

13. He found that the net profit of Vimta Labs was 61.7%, Lurgi India Co. Ltd. was 18.9% and Alphangeo India Ltd. was 56.25% and the average margin of the comparables was 45.6% as compared to that of the assessee at 16.26%. Therefore, he issued a show cause notice to the assessee proposing to make the transfer pricing adjustment u/s 92CA of the Act. The assessee however, submitted its objections vide letters dated 20.11.2006 and 24.11.2006. The assessee vide letter dated 5.12.2006 filed a summary of its objections stating that the comparables adopted by the TPO did not satisfy the FAR analysis with that of the assessee. The TPO, however held that the assessee is providing ‘Research and Development’ services and not ‘computer software development services’ as claimed by the assessee and that the delivery model cannot be confused with the functions and that the service agreements of the assessee with its affiliates as well as the information available from the website do not speak of software development and, therefore, the enterprises developing software cannot be used as comparables. As regards the risk free environment in which the assessee claimed to be working, he held that the risk of success and failure is common to any R & D undertaking and, therefore, there is no difference in the risk level of the assessee and the comparables chosen by the TPO. As regards the assessee’s contention that the assessee should be considered as ITES company as it is so treated by NASSCOM, he held that the comparable companies are to be identified on the basis of the functions carried out by the assessee and not on the basis of the category considered by NASSCOM.

14. Pursuant to the TPO’s direction, the assessee also had done a fresh search with an emphasis primarily on the functions performed i.e IT enabled engineering services and research and development. It also considered the contemporaneously available data in the data base. On the basis of the said search, the assessee arrived at 10 comparables which are functionally similar to that of the tax payer and are in the software industry. The TPO however held that the assessee is again looking at only IT and ITES companies i.e who are predominately rendering software services and ITES, BPO services who are functionally dissimilar to that of the tax payer. However, as some of the comparables offered by the tax payer now, are having engineering services, the TPO accepted the same as comparables along with those proposed by the TPO and thereafter proceeded to determine the ALP by adopting the TNMM as the most appropriate method. As regards the risk free environment claimed by the assessee, he observed that the risk prevailing on both the comparables and the assessee is identical. The TPO then proceeded to determine the ALP and made the adjustment of Rs. 22,24,27,024/- u/s 92CA of the Act. Based on the same, the AO also made the adjustment to the returned income of the assessee.

15. Aggrieved, the assessee preferred an appeal before the CIT(A) reiterating the submissions made by it before the AO. The CIT(A) agreed with the comparables finally adopted by the TPO and TP adjustment to the ALP but however directed the AO to allow the working capital adjustment and depreciation adjustment and to re-compute the total income of the assessee accordingly. After making the said adjustments in the order giving effect to the order of the CIT(A), there has been no addition to the total income of the assessee. However on the adoption of the comparables i.e Vimta Labs Ltd., Alphangeo India Ltd. and Lurgi India Co. Ltd., the assessee is in appeal before us. Similarly for the assessment year 2005-06 also the assessee is in appeal before us against the adoption of Vimta Labs and Alphangeo India Ltd. as comparables for making the TP adjustments. For the assessment year 2006-07, the assessee is aggrieved by the adoption of Vimta Labs Ltd., and Celestial Labs Ltd., as comparables by the TPO and as confirmed by the DRP.

16. The learned Sr. counsel for the assessee, Shri N.V Venkataraman, while reiterating the assessee’s submissions made before the authorities below for all the three years, submitted that there are no additions made on account of TP adjustments for assessment year 2004-05 and 2005-06 and, therefore, the grounds are only on erroneous inclusion of certain comparables as these comparables have been adopted by the TPO for the assessment year 2006-07 also without giving any opportunity of hearing and adjustment was made to the ALP. On the nature of assessee’s activities, the learned counsel for the assessee submitted that the assessee is exporting the computer programs, customized electronic data and engineering analysis and designs. He submitted that the TPO, has, without any basis completely disregarded the detailed explanation provided by the assessee as being involved in Software Development and not as ‘Research and Development’. According to the learned counsel for the assessee, the assessee is a software development company and, therefore, companies which are involved in the business of software development only are to be considered as comparables for the purposes of computing the ALP.

17. The learned DR however submitted that the assessee is engaged in contract research and development activity and derives income from foreign principals/associated enterprises and merely because the result of such research and development is delivered to its AE’s in customized electronic data, it would not make the nature of services as software development. Thus according to him, the TPO has rightly treated the assessee as engaged in contract research and development, technical engineering services and accordingly selected the relevant comparables.

18. So the primary and basic question before us is to determine the nature of assessee’s activities as it would determine the roadmap for making the search for and adopting of the comparables.

19. Having heard both the parties and having considered their rival contentions and the material on record, we find that the assessee is a service provider for research and development in various fields of engineering (including computer software) as enumerated in the agreements between the assessee and its associated enterprises reproduced in para 8 and 9 above and the result of such research and development is being delivered to the clients/associated enterprise in the form of customized computer data through network/internet. Thus, even as per the assessee’s submissions, it is conducting the research and development through its multi-disciplinary R&D centre JFWTC and its activities are for several streams/areas including Information Technology.

Thus it can be seen that it is catering to nearly all of GE’s diverse business worldwide touching nearly every scientific discipline across the spectrum such as mechanical engineering, electronic and electrical and metallurgy, catalysis and advanced chemistry, polymer science and new synthetic materials, power electronics etc. Therefore, as rightly held by the TPO, the assessee is not into simple software development but is engaged in research and development in technical and engineering services on contract basis. Therefore, the TPO has rightly rejected the TP study conducted by the assessee and has rightly proceeded to select his own comparables in the field of Research and Development and redetermine the ALP.

20. The next question to be considered by us is as to whether the comparables adopted by the TPO are relevant and comparable to the assessee. For assessment year 2004-05, the assessee’s objection is to the adoption of Vimta Labs, Alphageo Labs, Lurgi India Co. Ltd., while for the assessment year 2005-06 ad 2006-07, the assessee’s objection is against the adoption of Celestial Labs and Vimta Labs as comparables. But before us, the learned counsel for the assessee has advanced arguments contesting the adoption of Vimta Labs, Celestial Labs only, as they have resulted in adjustments to the ALP for assessment year 2006-07. It is submitted by the learned counsel for the assessee that in the show-cause notice issued by the TPO, Vimta Labs and Celestial Labs did not find place, but in the final TP order, these two companies have been considered as comparables and their margins considered which is in violation of principles of natural justice. He submitted that the assessee has raised its objections before the DRP which only confirmed the order of the AO holding that assessee’s objection to these comparables were considered by the TPO in the earlier assessment years. According to the ld. counsel for the assessee, Vimta labs and Celestial Labs are not at all comparable to the assessee for the following reasons :

(1)  They are diversified companies engaged in dissimilar activities like earning income from franchisee model and products.

(2)  No separate segment reporting is available in their annual report and even otherwise also, their margins cannot be adjusted to make them comparable with the assessee.

(3) The assessee is working in risk free atmosphere, whereas Vimta Labs and Celestial Labs are facing various risks that cannot be quantified or adjusted.

21. The learned counsel for the assessee has drawn our attention to the methods prescribed for determining the ALP in Rule 10B of IT Rules and submitted that as per the TPO, TNMM method is most appropriate method. He submitted that as provided under rule 10B(e) of Income-tax Rules, for computing the ALP under TNMM, the TPO has to conduct FAR analysis i.e functions performed taking into account the assets employed and risks assumed and only after such an exercise, could a comparable be selected by the TPO. He submitted that even if the assessee is to be considered as a Research and Development company, the comparables have to be of the same industry in which the assessee is into the research and development i.e., the field of Engineering and Technology. He submitted that both Vimta Labs and Celestial Labs are into the research and development in the field of pharmaceuticals which is entirely different from the field of engineering and technology.

22. As far as adoption of Vimta Labs is concerned, he submitted that the TPO has selected Vimta Labs for the assessment years 2004-05 and 2005-06 merely because at that time Vimta Labs was classified in ‘Prowess’ database under the heading ‘Technical consultancy and engineering services’ or ‘Research and Development’. He submitted that for the assessment year 2006-07, however, Vimta Labs was reclassified in the aforesaid database itself as ‘Drugs, medicines and allied products’. He submitted that there was no change in the business activities of Vimta Labs for the assessment year 2006-07 as compared to the assessment years 2004-05 and 2005-06 and, therefore, its reclassification in the database as a Drug Company for the assessment year 2006-07 shows that Vimta Labs was wrongly classified as ‘Technical Consultancy and Engineering Services’ or ‘R & D’ for assessment years 2004-05 & 2005-06. He further submitted that the subsequent classification/reclassification continues till date which also establishes that reclassification truly described the activities carried out by Vimta Labs right from the assessment years 2004-05 onwards and, therefore, for the assessment year 2006-07, Vimta Labs did not appear in the search criteria but the TPO has cherry picked Vimta Labs only because the same was selected in the assessment years 2004-05 and 2005-06.

23. The learned counsel for the assessee further submitted that even as per the FAR analysis, the Vimta Labs could not have been selected as a comparable for the following reasons :

(I)  Functions Performed :

(1)  Vimta is a clinical trial company and is engaged in conducting testing of new pharmaceutical drugs on humans and animals to study the effects of drugs, side effects associated with increasing doses, and, if possible, to gain early evidence on their effectiveness.

(2)  Vimta Labs maintains a database of 20,000 healthy male and female volunteers to conduct clinical trials.

(3)  It has so far conducted over 600 bio-availability and bioequivalence studies and clinical trials involving more than 120 drugs.

(4)  It has a state of the art barrier maintained animal facility designed to conduct experiments using rodents, rabbits and beagle dogs.

(5)  It has entered the scheme of Clinical reference laboratory services in 1999 and offers more than 600 laboratory tests for clinical programs and also provides diagnostic services such as lipid profile, diabetes, kidney, anemia, HIV and hepatitis tests etc.,

(6)  It works on franchisee model;

(7)  It focuses on analytical studies to check water and food quality, and on testing for effectiveness and drugs to meet the requirements under the various standard organization, such as Bureau of Indian Standards , FDA etc. and other statutory agencies.

(8)  The services provided by Vimta Labs comprises of site assessments, environmental audits, environmental impact statements, risk assessments and waste management for project evaluation to private and public corporations and government agencies such as Ministry of Forest and Environment. In view of the hazardous nature of carrying out these assessments, the risk assumed is significantly high which is also reflected in the pricing of these assessment studies.

 II  Assets employed :

Vimta Labs has made significant investments in both tangible and intangible assets and the asset/sale ratio for Vimta Labs work out 2.89% as opposed to 0.99% for the assessee.

III.  Risks assumed :

(a)  Entrepreneurial risk:- The assessee being a captive service provider operates on a risk free model, whereas Vimta Labs is entrepreneurial company and assumed significant risks.

(b)  Liability risk : Due to human involvement and life threatening nature of the assessment and clinical research/trials, the risk assumed by Vimta Labs is significantly high which is reflected in the pricing for the fact that humans are involved in the clinical trial/research. The learned counsel for the assessee has relied upon various websites which are in public domain to demonstrate that Vimta Labs is experimenting on humans and it has compensated for the damage caused by its experiments on the humans.

(c)  Regulatory risks : Chemical trails industry is increasingly being regulated and profitability of participants would also depend upon regulatory changes.

24. In addition to the above, the learned counsel for the assessee submitted that the TPO has himself adopted the filter of employee cost being less than 25% as a filter for rejecting various companies shortlisted by the assessee. He submitted that the TPO should follow uniformly the same filter while searching for and adopting the comparables. He submitted that Vimta Labs fails the employee cost filter adopted by the TPO as employee cost of the assessee is 32% in 2004-05, 38% in 2005-06 and 42% in 2006-07 as against the employee cost of Vimta Labs being 13% in 2004-05, 14% in 2005-06 and 16% in 2006-07. As the employee cost of Vimta Labs is less than 25% in all the three assessment years, according to the learned counsel for the assessee, it should be excluded from the list of comparables.

25. As regards the adoption of Celestial Labs as a comparable, the learned counsel for the assessee submitted that it is also functionally different from the assessee because of the following features :

(a)  Celestial Labs is into development and manufacture and distribution of bio and IT products;

(b)  Development and manufacture of molecules and enzymes ;

(c)  Clinical research and trial business;

(d)  On line portal for live ayurvedic consultation and trading of herbal products – Sanjivini;

(e)  Contract manufacturing of pharmaceutical products such as creams, lotions, tablets, syrups and capsules.;

(f)  SAP implementation services; and

(g)  It has already been licenced 55 herbal products for manufacturing. Some of the products include Bioliv syrup, Cel-digest syrup etc.

26. He submitted that it is evident from the annual report of Celestial Labs for the assessment year 2006-07, that it is a product driven company. He submitted that Mumbai bench of this Tribunal in the case of Tevapharm (P.) Ltd. v. Addl. CIT [2012] 50 SOT 150 (Mum.) (URO)  has considered the fact that the activities undertaken by the Celestial Labs are in the nature of providing host of IT related services and some trading activity which is not comparable to the assessee therein and, therefore, ought not to be considered as a comparable even in this case. As regards assets employed by Celestial Labs, the learned counsel for the assessee submitted that -

(a)  It has invested significantly in assets and the assets/sales ratio for Celestial Labs works out to be 1.56 as opposed to 0.96 for the assessee.

(b)  It also invested in developing new products in intangible assets and its expenditure on new development accounts for 33% of the total assets.

(c)  The Celestial Labs owns significant intangible assets and has applied to protect the IPR by filing the copyrights and patents for Celesuite, Vitiligo and Multiple Cancer.

(d)  As per the website content, Celestial currently owns the following intangible assets:-Copy right/patent approval for different tools and packages under informatics and bioinformatics category.

(e)  New Drug Molecules applicable for Vitilogo, Psoriasis, Accelerated wound healing, Anti wrinkles and Skin tanning.

(f)  32 herbal formulations in the different category are under process and filing with patent office.

27. As far as risks assumed by Celestial Labs are concerned, the learned counsel for the assessee submitted that Celestial is a entrepreneurial company and assumes significant risks as opposed to assessee which operates in a risk free model. He submitted that being a product-company dealing in medical products, Celestial bears significant product liability risks and is also subject to clinical trials segment subject to same risks as Vimta Labs.

28. Thus, according to the learned counsel for the assessee, both Vimta Labs and Celestial Labs should be excluded from the list of comparables and if done so, the assessee’s margin would fall within the ALP of the comparable companies or + 5% thereof and no adjustment would be necessary.

29. The learned DR however, placed reliance upon the orders of the authorities below and submitted that the CIT(A) in his order for the assessment year 2004-05 has discussed at length the nature of the activities of the assessee and the functions performed to hold that the assessee was a service provider working on research and development and also doing engineering analysis and the results of which are captured/computerized and transferred through electronic media, which are merely means of delivery to the AE.

30. As regards the adoption of Vimta Labs as a comparable, he submitted that the assessee is into contract ‘Research and Development’ as in the case of Vimta and Celestial Labs and, therefore, they are comparable companies.

31. As regards the reliance by the learned counsel for the assessee on the decision of the Tribunal in the case of Tevapharm (P.) Ltd. (cited Supra) for exclusion of Celestial Labs from the list of comparables, the ld. DR submitted that the same is distinguishable on facts as in the said case it was directed to be excluded on the ground that Tevapharm was a pharmaceutical company whereas Celestial was dealing with IT related services where as in the case before us, the assessee was also dealing with IT related services as well as engineering services. Hence, according to the DR, even applying the decision of the Tribunal in the case of Tevapharma, Celestial is comparable to the assessee on the basis of its functions.

32. Having heard both the parties and having considered their rival contentions and the material on record, we find that there is no dispute as regards the most appropriate method to be adopted for computing the ALP. The TNMM has been considered as the most appropriate method. We have already held that the assessee is engaged in the activity of research and development and technical and engineering services. For determining the ALP under the TNMM method, the FAR analysis is very essential as is provided under Rule 10B of the Income-tax Rules. As per the said provisions, it is essential to consider the functions performed; assets employed and risks encountered by the assessee company as well as the comparable companies before embarking upon the determination of the ALP. So it is essential to consider the correct nature of functions of the assessee to search for the comparables which are engaged in the similar functions. It is also essential to take a note of the dissimilarities between the functions performed by the assessee and the comparable companies before adopting the same as comparables and to make suitable adjustments for the said dissimilarities wherever possible. As rightly pointed out by the TPO and the CIT(A)/DRP for the relevant assessment years, the assessee is not in the business of software development but it is in the business of research and development in various fields of engineering including the computer software. The outcome of the research and development conducted by the assessee is delivered to the customers/AE through electronic media. The mode of delivery of result of research and development cannot determine the nature of the functions/activities of the assessee. Therefore, the TPO was right in conducting search on the data base ‘prowess’ using the word ‘research and development’.

33. Now comes the question of selection of comparables. The learned counsel for the assessee has forcefully argued that even if the assessee is to be considered a Research and Development company, then the comparables have to be of the same industry in which the assessee is doing research and development. If this argument of the learned counsel for assessee is accepted, then the comparables selected/shortlisted by the assessee from the ITES Industry are also liable to be rejected as they are not from the same industry. Thus, the argument of the learned counsel for the assessee that the functions are synonymous with or analogous to the industry and the comparable companies have to be from the same industry for comparability analysis under TNMM is not in tune with the principles enunciated by the guidelines of OECD or United Nations Manual which advocate that under TNMM only broad functional and product comparability is to be considered as net margins are less influenced by differences in products and functions.

34. As per the principles of comparability, controlled and uncontrolled transactions are regarded as comparable if their economically relevant attributes and the circumstances surrounding them are sufficiently similar to provide a reliable measure of an arm’s length result. However, in reality, two transactions are seldom completely alike. To be comparable does not mean that the two transactions are necessarily identical, but that either none of the differences between them could materially affect the arm’s length price or, where such material differences exist, then reasonably accurate adjustments can be made to eliminate their effect. It is important to note that the type and attributes of the comparables available in a given situation typically determine the most appropriate transfer pricing method. In general, closely comparable products/services are required if the comparable uncontrolled price (“CUP”) method is used for arms’ length pricing; the resale price, cost-plus methods generally require a lesser degree of products or services comparability and may be appropriate if functional comparables are available. The TNMM requires only broad functional and product/services comparability. In many instances, it will be possible to use ‘imperfect’ comparables, e.g., comparables from another industry sector, possibly adjusted to eliminate or reduce the differences between them and the controlled transaction. Hence, the contention of the assessee that the comparables have to be of R & D companies from the same industry is not appropriate for TNMM.

35. As far as adoption of Vimta Labs as a comparable is concerned, the TPO’s stand is that Vimta Labs is a leading provider of multi-disciplinary contract research and testing services. So also, the assessee has a multi-disciplinary Research & Development Centre. Also, the company’s functions, i.e., research and development are similar to that of the tax payer in all respects.

36. As detailed in earlier paras, the objection of the assessee to the adoption of Vimta Labs as a comparable can be summarized as under:-

(i)  It was selected as a comparable by the TPO in A.Y 2004-05 merely because it was classified under ‘Technical Consultancy and Engineering Services’ or Research and Development’ in the database. However, it was reclassified as ‘Drugs, medicines and allied products’ for A.Y 2006-07. Hence, it was selected as a comparable by the TPO only because of wrong classification in the earlier years.

The issue of regarding wrong classification of the company in the database has been raised by the assessee for the first time before us. There is no mention of the same in any of the documents in our record. Whether the change in classification is due to wrong classification in the earlier years or whether there was a change in functional profile necessitating such a change in classification needs to be examined.

(ii)  As per the FAR analysis, it cannot be selected as a comparable. It is a clinical trial company engaged in testing of new pharmaceutical drugs and works on franchisee model. It has significant investments in tangible and intangible assets and the assets/sales ratio is substantially higher. Being an entrepreneurial company, it assumes significant risks and also has high liability risk due to human involvement and life threatening nature of the clinical trials.

The assessee’s contention that it is a clinical trial company is only partly true. As the TPO has mentioned, it is into multi-disciplinary research services. It provides contract and research testing services in other areas like analytical testing and environment monitoring and impact assessment. While the assessee has totally ignored these activities of the company, the TPO has not examined as to whether these services are significant enough to consider the activity of this company as ‘technical consultancy & engineering services and R & D.

The contention that the company has significant investments in both tangible and intangible assets does not, by itself, make the company dissimilar. After all as noted by the TPO, even the R&D centre of the assessee is reported to have filed for more than 185 patents and has been granted quite a few of them. Unless it is analyzed as to how these intangible assets are valued, it may not be appropriate to conclude that the company is dissimilar in this regard.

(iii)  Also, this company fails the filter adopted by the TPO, viz., employee cost less than 25%. As the employee cost for the company is less than 25% in all the three years under consideration, it should be excluded from the list of comparables.

This contention of the assessee that Vimta Labs fails the filter of employee cost filter has been advanced for the first time before us. This point has not been examined by the AO and the CIT(A). In fact both the TPO and the CIT(A) have recorded a finding that the assessee has not questioned the search process at all. Hence, this claim that the assessee fails the employee cost filter for all the three years needs to be examined.

(iv)  Assessee is working in a risk free atmosphere while Vimta Labs is facing lot of clinical test failure risk and also regulatory risks.

It is the contention of the assessee that it is totally risk free and all the substantive risks are borne by the AE. Identification of risk and the party who bears such risks are important steps in comparability analysis. The conduct of the parties is key to determine whether the actual allocation of risk conforms to contractual risk allocation. Allocation of risk depends upon ability of the parties to the transaction to exercise control over risk. Core functions, key responsibilities, key decision making and level of individual responsibility for the key decisions are important factors to identify the party which has control over the risks.

36. The notion that risk can be controlled remotely by the parent company and that the Indian subsidiary engaged in core functions, such as carrying out research and development activities or providing services are risk free entities is something which needs to be demonstrated by the assessee. The conventional wisdom is that the core function of R & D services are located in India, which in turn require important strategic decisions by management and employees of Indian subsidiaries or related party to design the direction of R&D activities or providing services and control over the operational and other risks. In these circumstances, the ability of the parent company to exercise control over the risk – remotely and from a place where core functions of R & D and services are not located – is very limited. Under these circumstances, the claim of the assessee that it is totally risk free is not acceptable. However, the relative risk profile of the comparable company, particularly on the factors of human involvement in the clinical trails needs to be evaluated and a determination made whether such differences in risk needs to be adjusted or whether such risks are not amenable for adjustment at all, as claimed by the assessee. In view of all the above, the issue of comparability of Vimta Labs is remanded back to the AO/TPO with a direction that the comparability may be analyzed in the light of the observations made above.

37. Now let us examine the correctness or otherwise of the comparables adopted by the TPO for all the three assessment years. Though the assessee has not specifically advanced arguments for exclusion of the comparables raised in its grounds of appeal for the assessment year 2004-05 and 2005-06, it is necessary to consider the appropriateness of the action of the TPO for the said years also as the detailed reasoning for the said selection/ adoption are mentioned therein. For the purposes of convenience and ease of comparison the details of the final list of comparables adopted by the TPO and their margins for the three assessment years are tabulated hereunder :

2004-05 2005-06 2006-07
(1) Alphangeo India Ltd. 56.25 26.73
(2) Vimta Labs Ltd., 61.7 75.93 57.80
(3) Lurgi Labs Ltd., 18.9 -6.90
(4) Celestial Labs Ltd., 48.15
(5) Geometric Ltd., 29.39 20.34 6.70
(6) Tata Elxi 20.79 24.35  27.65
(7) Sasken Communication Tech Ltd, 13.13 13.90
(8) Infotech Enterprises Ltd., 19.12
(9) Rolta India Ltd., 28.06
(10) ) Zigma Software Ltd. 16.47 14.42
Arithmetic mean 29.37 25.81 30.84
Assessee’s margins 16.26% 14.25% 16.28%

38. From the above table, it can be seen that the comparables uniformly adopted/offered by both assessee and the TPO for all the three years are Tata Elxi and Geometric Ltd., while Sasken Communication Tech. Ltd., is adopted for 2004-05 and 2006-07 and Zigma Software is adopted for 2004-05 and 2005-06.

40. The comparables proposed and retained by the TPO are (1) Vimta Labs for all the three years, (2) Alphangeo India Ltd., for AYs 2004-05 and 2005-06 (3) Lurgi Labs Ltd., for AYs 2004-05 and 2005-06 and 4) Celestial Labs Ltd. for AY 2006-07.

41. It is also to be seen that the assessee has objected to the adoption of Alphangeo and Vimta Labs in both AYs 2004-05 and 2005-06, while it objected to adoption of Lurgi Labs in AY 2004-05 only while no objection was raised for its adoption in AY 2005-06 either before the CIT(A) or before this Tribunal. This is probably because Lurgi Labs incurred loss during AY 2005-06 which when considered by the TPO has resulted in lower arithmetic mean benefitted the assessee.

42. Further, we also had an opportunity to go through the TP order and assessee’s objection to the TPO for AY 2008-09 the copies of which are filed by the assessee before us in connection with the other issue arising in the appeal for A.Y 2006-07 i.e., the TP adjustment made towards interest on external commercial borrowing. We find that for the A.Y 2008-09 also, the TPO proposed to adopt Vimta Labs and Celestial Bio Labs Ltd. as comparables with margins of 18% and 88% respectively. From the reply of the assessee to the show cause notice of the TPO proposing TP adjustments, we find that the assessee had raised objections to Celestial Labs and Engineers India Ltd. and Oil Field Instrumentation India Ltd but did not raise any objection to adoption of Vimta Labs as a comparable for A.Y 2008-09, which goes to show that it has accepted Vimta Labs as a comparable for the relevant A.Y probably because its margin was only 18% for the relevant A.Y. The Celestial Labs was retained by the TPO while the other two companies were excluded.

43. From the above details, it can be seen that the assessee is not adopting a uniform approach for objecting to the comparables proposed by the TPO. As regards Lugri Labs, it appeals against its adoption in A.Y 2004-05 while it accepts the decision of TPO for A.Y 2005-06. As regards Vimta Labs, it appeals against its adoption in A.Ys 2004-05, 2005-06, & 2006-07 while it does not even object to the proposal of TPO for its adoption in A.Y 2008-09. Such cherry picking by the assessee cannot be allowed. Uniformity and consistently in approach is essential for both the Revenue as well as the assessee alike unless the circumstances warrant otherwise. The objections of the assessee to Lurgi Labs and Vimta Labs was that they are functionally different. There is evidently no change in the functional activities of Lurgi in A.Y 2004-05 and 2005-06. Likewise Vimta Labs also has been in Pharmaceutical industry doing research and development in all the relevant AYs. In fact, it is the case of the assessee that from A.Y 2006-07, it has been reclassified as ‘Drugs, medicines and allied products’ and hence is not comparable at all. Then it is not clear as to how it can be adopted as a comparable for A.Y 2008-09 when its functions are no different from A.Y 2006-07.

44. In view of the above observations and also inconsistencies in the approach of the assessee and also in view of the fact that the assessee was not given an opportunity of hearing for A.Y 2006-07 against adoption of Vimta Labs as a comparable and also in view assessee’s submissions that there has been a change in the classification of the Vimta Labs in the database in AY 2006-07, and also additional evidence filed before us with regard to the risks encountered by Vimta Labs and Celestial Labs, we deem it fit and proper to remand the issue to the file of the AO/TPO for reconsideration of the issue de novo for all the A.Ys. The AO/TPO shall consider the objections of the assessee in detail and shall give a fair opportunity of hearing to the assessee before completing the proceedings in accordance with law.

45. In the assessment year 2004-05, the assessee has also raised grounds No.13 to 15 against the order of the CIT(A) confirming the order of the AO as regards the computation of deduction u/s 10A of the Income-tax Act.

46. The brief facts of the case are that for the assessment year 2004-05, the assessee earned a profit of Rs. 10,90,56,643/- from 10A undertaking and incurred a loss of Rs. 1,90,02,182/- from non-10A business activities. Further, the assessee also had brought forward losses of 10A undertaking for the assessment year 2002-03 and 2003-04 aggregating to Rs. 22,95,47,384/-. In its return of income for the assessment year 2004-05, the assessee computed its total income by first claiming the deduction of profit u/s 10A of the undertaking at Rs. 10,90,54,643/- and thereafter the set off of carried forward losses of non 10A business activities of Rs. 1,90,02,182/- and also the brought forward losses of 10A undertaking at Rs.22,95,47,384/-. The Assessing Officer however computed the deduction u/s 10A of the Income-tax Act after first reducing the profits of the 10A undertaking by brought forward losses of 10A undertaking from the earlier years and thereafter further reduced the income by the losses from the non-10A undertaking and thereafter arrived at ‘Nil’ deduction u/s 10A of the Act. Against the said computation, the assessee filed an appeal before the CIT(A) who confirmed the action of the AO and the assessee is in second appeal before us.

47. The learned counsel for the assessee submitted that the 10A deduction/exemption should be allowed from its source i.e 10A unit itself and accordingly the said deduction/exemption should be allowed at the time of calculation of business income itself. Thus according to him, 10A profit will not at all enter the computation of business income and the same should be allowed before arriving at the gross total income and before setting off of losses, whether 10A losses or non 10A losses. He submitted that in the case of the assessee, if sec. 10A deduction/exemption is allowed at source itself, then there will be no business profit left against which the loss of non-10A units and brought forward losses of 10A units can be set off and, therefore, the said losses will be eligible to be carried forward to the subsequent years. In support of its above contentions, the assessee has placed reliance upon the following decisions :

(1)  CIT v. Yokogawa India Ltd. [2012] 341 ITR 385

(2)  Hindustan Uniliver Ltd. v. Dy. CIT [2010] 325 ITR 102

(3)  CIT v. TEI Technologies [IT Appeal No.4025/2012 (Delhi, HC)]

48. The learned DR, however supported the orders of the authorities below.

49. Having heard both the parties and having considered their rival contentions, we find that this issue is covered by the decision of the Hon’ble High Court of Karnataka in the case of Yokogawa India (cited Supra), wherein it has been held that for computing the deduction u/s 10A of the Act, the profit of eligible units have to be deducted at source and do not enter into the computation of income and as a consequence of which, the losses suffered by non eligible units cannot be set off against the profits of eligible units. Further it has been held that the depreciation and business loss of eligible units relating to the assessment year 2000-01 onwards is eligible for set off and carry forward for set off against the income post tax holiday as per the amended provision of sec. 10A(vi) amended with retrospective effect from 1/4/2001. Taking note of the above amendments, the Hon’ble High Court of Karnataka has held that it is necessary that notional computation of business income and depreciation should be made for each year of the tax holiday period and such loss is eligible to be carried forward in the post tax holiday period and, therefore, for the relevant assessment year, the question of setting off of the loss of current years or the previous brought forward business losses of units against the profits of 10A unit does not arise. This issue is also covered by the other decisions relied upon by the learned counsel for the assessee.

50. Respectfully following the decision of the jurisdictional High court, we hold that the losses of non 10A units cannot be set off against the profits of 10A unit and the brought forward losses of 10A units for the assessment years 2002-03, 2003-04 cannot be set off against the current years 10A profits but can be set off against the profits of the post tax holiday period. This ground of appeal is accordingly allowed.

51. In the result, the appeal for the assessment year 2004-05 is allowed.

52. For the assessment year 2005-06, the only issue is with regard to the transfer pricing adjustment made on account of research and development activity carried on by the assessee and as the issue has already been remanded to the file of the AO/TPO in our order for the assessment year 2004-05, this ground of appeal of the assessee is also remanded to the AO/TPO for de novo consideration.

53. For the A.Y 2006-07, in addition to the above, TP adjustment to the ALP on account of Research and Development activity, the assessee has also raised ground of appeal No.4 against the order of the Assessing Officer making TP adjustment to the ALP on account of interest on external commercial borrowings.

54. The brief facts of the case are that the assessee had obtained two commercial borrowings from its AE’s (GE India & Pacific Mauritius Ltd.) These were obtained under long term loan agreements entered in 2001 and interest rates of such ECBs were fixed @ 7.5% and 8.49% which was determined based on business and economic circumstances at the time of entering into loan agreement and these ECBs were not renegotiated on a year to year basis. According to the assessee, the interest rates and the loan agreements were in accordance with ECB guidelines issued by the Government of India. The AO made a reference to the TPO u/s 92CA of the Income-tax Act for determination of the ALP of interest on ECB. The TPO made the adjustments to the ALP on account of interest on ECB and the AO proposed the addition in the draft assessment order. The assessee raised objections before the DRP. DRP, however, confirmed the draft assessment order and the assessee is in second appeal before us.

55. It is submitted by the learned counsel for the assessee that the interest rates of these borrowings were consistently accepted by the Revenue in the earlier assessment years i.e 2002-03, 2003-04 and 2004-05, 2005-06 and also for the subsequent assessment years 2008-09. He submitted that for the assessment year 2008-09, this issue was specially raised by the TPO vide show cause notice dated 11/10/2011 but no TP adjustment made after considering the submissions of the assessee dated 27/10/2011. In support of his contentions, the learned counsel for the assessee has filed the copies of the show cause notice of the TPO, the assessee’s submissions in response to the same and also the TPO’s order for the assessment year 2008-09. In addition to the above evidence and in support of its contentions that the interest rates should be determined based on the interest rates prevailing at the time of availing the loan, the learned counsel for the assessee has placed reliance upon the decision of the Delhi ITAT in the case of ITO v. Maharishi Solar Technology (P.) Ltd. in ITA No.4561 and 4393 of 2009. Thus, the learned AR prayed that the addition relating to the above adjustment may be deleted.

56. The learned DR, on the other hand, supported the orders of the authorities below and submitted that for the earlier assessment years, the TPO has not examined the issue at large/length and, therefore, it cannot be said that the issue has been decided on merits in favour of the assessee. In support of his contentions regarding the interest rate on ECB to be adopted for the relevant A.Y, he submitted that two loans or external commercial borrowings were between two cross border entities and, therefore, resulted in an international transaction and each transaction has to be considered every year whether the same is at ALP as the rate of interest on such loans is integral part of determination of ALP. In support of his contention, he placed reliance upon the decision of the Delhi Bench of the Tribunal in the case of Perot Systems TSI (India) Ltd. v. Dy. CIT [2010] 37 SOT 358 (Delhi).

57. Having heard both the parties and having considered their rival contentions, we find that two ECB loans have been obtained by the assessee in the year 2000-01 at the fixed rate of interest at 7.5% and 8.49% respectively. As rightly submitted by the learned counsel for the assessee, the interest rate is depending upon the credit rating of the borrowings and also on the prices and economic conditions prevailing at the time of advancing the loan. The assessee has obtained the loans in the year 2001 and the issue has been considered by the TPO for the assessment years 2004-05 and 2005-06 and also for the assessment year 2008-09. After considering the assessee’s submissions, the TPO accepted the rate of interest fixed in the loan agreements. In view of rules of uniformity and consistency we are of the opinion that the same approach is to be adopted this year also.

58. In view of the above, as the Assessing Officer for the assessment year 2002-03 onwards up to the assessment year 2008-09 except for the assessment year 2006-07 has accepted the rate of interest as fixed in the loan agreement, we hold that the TP adjustment on account of the interest on external commercial borrowings for this assessment year is not called for.

59. In the result, the assessee’s ground of appeal No.4 for the assessment year 2006-07 is allowed.

60. In addition to the above, the assessee has also raised ground No.5 against exclusions/deduction of telecommunication expenses of Rs. 3,25,98,610/- from export turnover and travelling expenses incurred in foreign currency of Rs. 90,92,976/- from the export turnover but not making the corresponding reduction from the total turnover for the purpose of computation of deduction u/s 10A of the Income-tax Act. We find that this issue is now covered in favour of the assessee by the decision of jurisdictional high court in the case of Tata Elxi Pvt. Ltd., wherein it has been held when any expenditure is reduced from the export turnover, then the same should also be reduced from the total turnover for the purposes of computation of deduction u/s 10A of the Income-tax Act. Therefore, AO is directed accordingly.

61. In the result, the assessee’s appeals are allowed for statistical purposes.

Sandeep Kanoi

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