ITAT Bangalore Accepts assessee’s plea to exclude comparables failing turnover filter

CAE Simulation Technologies Pvt. Ltd. Vs DCIT (ITAT Bangalore)

In CAE Simulation Technologies Pvt. Ltd. vs DCIT (ITAT Bangalore) for AY 2021–22, the assessee, a captive software development service provider to its Canadian AE on a time-and-material basis, benchmarked its international transaction under TNMM (OP/TC) and claimed its margin fell within the arm’s-length range. The TPO rejected the assessee’s comparables, selected a new set, and proposed an upward TP adjustment of ₹1.15 crore, along with interest on outstanding receivables at LIBOR + 450 bps, treating delays as a deemed loan. The DRP upheld both adjustments. The Tribunal held that the upper turnover filter is a recognized quantitative criterion in comparability analysis, and large turnover companies enjoy economies of scale and market advantages, making them non-comparable to small captive entities. Accordingly, it directed exclusion of high-turnover giants such as Infosys, TCS, Wipro, L&T Infotech, and others, and also excluded Aptus Software Labs Pvt. Ltd. for functional dissimilarity. On receivables, it reduced interest to LIBOR + 200 bps.

Facts:

• M/s. CAE Simulation Technologies Private Limited (“the assessee”) is a wholly owned subsidiary of CAE International Holdings Ltd., Canada, which in turn is a wholly owned subsidiary of CAE Incorporation, Canada. The assessee is engaged in providing contract software development services exclusively to its Associated Enterprises (“AEs”). These services are rendered in accordance with a Software Development Agreement dated 24.02.2006, along with amendments entered into on 27.03.2007 and 01.04.2012, under which the assessee is compensated on a time-and-material basis for software development activities performed for its AEs.
• For the Assessment Year 2021–22, the assessee filed its return of income on 15.03.2022 declaring a total income of Rs.1,93,22,170. As part of its transfer pricing compliance, the assessee benchmarked its international transactions relating to contract software development services using the Transactional Net Margin Method (“TNMM”) as the Most Appropriate Method, with Operating Profit to Total Cost (“OP/TC”) as the Profit Level Indicator. The assessee reported an OP/TC margin of 14% and identified 26 comparable companies, whose weighted average margins were 6.33% (35th percentile), 14.51% (65th percentile), and a median of 7.77%, thereby asserting that its margin fell within the permissible arm’s-length range.
• During the assessment proceedings, the Assessing Officer made a reference to the Transfer Pricing Officer (“TPO”) under section 92CA(1) of the Act for determining the arm’s-length price (“ALP”) of the international transactions. The TPO rejected the assessee’s benchmarking study and comparables, though he accepted TNMM as the appropriate method and OP/TC as the correct PLI. The TPO recomputed the assessee’s margin at 14.58% and conducted an independent search, ultimately selecting 18 comparables whose weighted average margins were 19.95% (35th percentile), 32.14% (65th percentile), and 25.09% (median). Based on this set, the TPO determined the ALP of the assessee’s transaction at Rs.13,79,40,807 as against the assessee’s reported operating revenue of Rs.12,63,47,637, resulting in a proposed upward transfer pricing adjustment of Rs.1,15,93,170.
• In addition to the margin-based adjustment, the TPO also made an interest adjustment on outstanding receivables, treating the delay as a deemed loan and applying an interest rate of LIBOR + 450 basis points.
• Relying on the TPO’s findings, the Assessing Officer issued a Draft Assessment Order under section 143(3) read with section 144C(1) on 18.12.2023, incorporating the proposed transfer pricing adjustments. The assessee filed detailed objections before the Dispute Resolution Panel (“DRP”). The DRP, however, upheld the action of the TPO both with respect to the selection of comparables and the computation of interest on receivables. Pursuant to the DRP’s directions, the Assessing Officer passed the Final Assessment Order on 18.10.2024 under section 143(3) read with section 144C(13), confirming the transfer pricing adjustment of Rs.1,15,93,170 and the interest adjustment.
• Aggrieved by the final order, the assessee has preferred the present appeal before the Income Tax Appellate Tribunal, Bengaluru, challenging the inclusion/exclusion of comparables, the computation of the arm’s-length margin, as well as the interest adjustment on outstanding receivables.

Issues:

• Whether the upper turnover filter should be applied in the selection of comparables for benchmarking software development services?
• Whether the TPO was justified in imputing interest on outstanding receivables at LIBOR + 450 bps?

Observations:

• The Tribunal began by noting that “in the present case, the only issue that arises is the applicability of the upper turnover filter.” It explained that a turnover filter is an essential component of transfer pricing comparability analysis and substantial variations in turnover can materially influence the determination of the Arm’s Length Price (ALP). It observed that a company with an extremely high turnover possesses advantages such as stronger bargaining power, brand influence, the ability to handle complex and large contracts, and superior resources, all of which render it incomparable to a small captive service provider.
• The Tribunal recorded that the TPO and DRP had taken a view that turnover filters should not be applied in the software services sector, stating that service companies incur limited fixed costs and that margins do not correlate with turnover.
• Rejecting this approach, the Tribunal held that “turnover filters are a recognized quantitative criterion in comparability analysis.” It emphasised that when the lower turnover filter of ₹1 crore is accepted by both sides, the application of an upper turnover filter logically follows the same principle. It further observed that both lower and upper turnover filters help eliminate companies that are either too small or disproportionately large, and that large-turnover companies generally enjoy economies of scale, stronger market presence, higher bargaining power, and greater capacity to undertake large-volume contracts, making them inherently non-comparable.
• The Tribunal then referred to international guidance, noting that OECD Transfer Pricing Guidelines (2022) expressly recognise size as a relevant quantitative factor. It quoted para 3.43 of the Guidelines, stating that higher turnover multiple times also shows that comparable company has higher market share compared to the tested entity. Similarly, it noted that the ICAI Guidance Note also supports applying turnover filters.
• Reinforcing this position, the Tribunal cited judicial precedents expressly relied upon in the order. It observed that the Hon’ble Bombay High Court in Pentair Water India Pvt. Ltd. [TS-566-HC-2015(BOM)-TP] and the Hon’ble Delhi High Court in Agnity Technologies [TS-189-HC-2013(DEL)-TP] held that companies with disproportionately high turnover must be excluded. The Tribunal also relied on the judgment of the Hon’ble Karnataka High Court in PCIT v. Softbrands India Pvt. Ltd. (406 ITR 513), which held that giant companies cannot be compared with small size companies.
• The Tribunal next examined the TPO’s empirical analysis and held that it did not support the rejection of turnover filters. It observed that the TPO had ignored instances of wide variation in margin” in large companies, and concluded that the above analysis does not give any indication that increase in turnover does not have any impact on profitability. It therefore held that application of an upper turnover filter was necessary to avoid distortion of arm’s-length results.
• The Tribunal then directed the exclusion of high-turnover companies, holding that for better comparability, large turnover companies should not be compared with the small companies, and specifically ordered the removal of Larsen & Toubro Infotech Ltd., Mindtree Ltd., Wipro Ltd., Infosys Ltd., TCS Ltd., Tata Elxsi Ltd., Cybage Software Ltd., and Nihilent Ltd.
• On the functional comparability of Aptus Software Labs Pvt. Ltd., the Tribunal accepted the assessee’s submissions that Aptus was engaged in cloud-based services, infrastructure management services, CMS support services, NOC operations and QA activities, all of which were different from the assessee’s software development services. Consequently, it held that this company is functionally not comparable and deserves to be excluded.
• Finally, regarding interest on outstanding receivables, the Tribunal noted that the TPO had applied LIBOR + 450 basis points, but found that no justification had been provided for such an approach. Observing that the receivables were from the holding company, and looking to the smallness of the amount and to give a quietus to the issue, the Tribunal directed the TPO to adopt LIBOR + 200 basis points.

FULL TEXT OF THE ORDER OF ITAT BANGALORE