Court :Income Tax Appellate Tribunal, Bangalore
Citation : SAP Labs India Private Limited
Brief : The Bangalore Bench of the Income Tax Appellate Tribunal (the Tribunal) has, in case of SAP Labs India Private Limited (the taxpayer), confirmed the benefit of 5 percent variation as a standard deduction, to the taxpayer as provided in Section 92C(2) of the Income Tax Act, 1961 (the Act). The Tribunal has further confirmed the inclusion of foreign exchange gain as part of the sale proceeds of the taxpayer and rejected abnormally high profit companies as com parables.
Facts of the case- The taxpayer was providing software development and related services to its associated enterprises. The taxpayer’s margin in respect of services was concluded to be below the margin reflected in comparable cases as selected by the Transfer Pricing Officer (TPO). The TPO had also disregarded certain items of income and expenditure to form part of the operating profit of the tax payer. On appeal to the Commissioner of Income –tax (Appeals) [CIT(A)], the TPO’s order was confirmed. Being aggrieved by the order of the CIT(A), the taxpayer preferred an appeal before the Tribunal. The key issues addressed and adjudicated by the Tribunal are discussed below.
Tribunal’s Ruling
Reference to TPO by AO is bad in law- The taxpayer contended that the AO had not established any purposive intention by the taxpayer to manipulate its Indian profits for the purpose of tax evasion. Accordingly the reference made by the AO to the TPO was bad in law. The Tribunal relied on the decision of Aztec Software & Technology Services Ltd. Vs ACIT ITA Nos. 585 & 584 /BANG / 2006, confirming that it is not necessary that the AO has to demonstrate evidences before reference is being made to the TPO. What is necessary for the reference is some materials to rely upon. Based on the above facts, the taxpayer’s objection was dismissed.
Our Comments –It would be important to highlight here that the issue dealt with is limited to the fact of reference by the AO to the TPO. In our view and as held by the Philips Software Center Pvt. Ltd. vs. ACIT [2008] 26 SOT 226 (Bang.), decision and per Circular No.14/2001 dated 12/12/2000 [252 ITR (st) 65], it is paramount that the TPO establish a case of avoidance of tax in framing an adverse TP order.
Change of Methodology during framing of Order– The taxpayer contended that the TPO shifted from one method to another in selecting the Most Appropriate Method (MAM) during the course of assessment. The Tribunal held that the selection of one of the methods as MAM has to be made by human skill and expertise. Shifting from one method to another method is inherent in a transfer pricing case. The only point is that the TPO should not compound different methods and use multiple approaches in determining the Arm’s Length Price (ALP). It is necessary for him to zero down on a particular method as the MAM. The Tribunal rejected the contentions of the taxpayer.
Our Comments –It would be pertinent to highlight the decision of the Delhi High Court in the case of Maruti Suzuki India Ltd. vs ACIT [2010-TII-01-HC-DEL-TP], wherein the Court has held that the TPO is under an obligation to issue requisite notice to the taxpayer, conveying explicit grounds on which the adjustment is proposed to be made. The TPO is obliged to provide reasonable opportunity to the taxpayer to controvert the grounds on which the adjustment is proposed.
Calculation of operating margin of the taxpayer– As regard the inclusion and exclusion of certain items of income and expenditure in computing the operating margin of the taxpayer the Tribunal held the following:
| Nature of expense | Treatment for computing OPM |
Reason |
| Foreign exchange fluctuation gain | To be included | It forms an integral part of the sales proceeds of export business |
| Donations | To form part of cost of services | Donations have been considered as expenditure incurred in ordinary course of business |
| Income-tax refunds |
To be excluded | Operating profit is computed without considering the Income? tax payments or refunds |
| Compensation payment towards termination of an agreement |
To be excluded | Expenditure is extra? ordinary in nature and non-routine and non? operating |
Our Comments –The ruling of the Tribunal would provide clarity and guidance to the Revenue as well as to the taxpayers.
Selection of Com-parables
- · The AO/ TPO had proceeded to normalize margins of companies making super profits on an adhoc basis. The Tribunal upheld the contention of the taxpayer in relation to rejecting companies earning abnormally high profit margins whose profits were normalized by the TPO. The Tribunal held that there is no provision in the Act or Rules to normalize such margins on an adhoc basis.
- · THE AO/ TPO had included certain super profit companies as com parables. The Tribunal held that the taxpayer has a limited role in generating what is called ‘commercial profit’ and it operated in a risk-mitigated environment. The TPO cannot select extreme cases as com parables to examine the ALP of the taxpayer under Transactional Net Margin Method and held that super profit companies cannot be considered as com parables in the present case.
- · The Tribunal also held that the tax payer had operated on a cost plus 6% basis. Accordingly, com parables with margins lower than the 6% mark-up should also be rejected to arrive at a reasonable profit level indicator.
Our Comments- The ruling of the Tribunal to reject com parables operating at margins less than the tax payer’s margin is without any cogent basis. The same would have the effect of increasing the overall margin of the com parables as the arithmetical mean would be calculated only on the basis of margins higher than that of the tax payer. This position is not consistent with the current provisions of law and the various rulings pronounced so far by the Tribunals.
Applicability of 5% variation – Adjudicating on the matter relating to allow ability of the 5 percent range while computing the ALP, the Tribunal held that the benefit of the 5 percent range should be made available to the taxpayer as standard deduction and adjustment should be restricted only on the net amount after allowing the benefit of 5 percent range. The Tribunal held that the amended proviso to Section 92C(2) of the Act is not applicable to the present case on hand. The new proviso in the Finance (No.2) Act 2009 is applicable to AY 2009-10 and on wards.
Our Comments- The view adopted by the Tribunal to allow 5 percent variation as standard deduction restricting the transfer pricing adjustment on the net amount, would provide relief to the taxpayers in pending litigation.
The above decision provides useful insights to the issues dealt within transfer pricing litigation being faced by the taxpayers in India. The ruling has cleared the ambiguity on whether foreign exchange fluctuations should be considered as operating or non-operating while computing the operating margin.
Mumbai Tribunal rules on deductibility of certain business expenditure
Recently, the Mumbai Bench of the Income-tax Appellate Tribunal (the Tribunal) in the case of DCIT v. Accenture Services Pvt. Ltd. (2010-TIOL-409-ITAT-MUM) held that the expression ‘for the purpose of business or profession’ used in Section 37(1) of the Income-tax Act, 1961 (the Act) for allowing expenditure is wide in scope and range.
The Tribunal further observed that expenses incurred by the taxpayer on Employees Stock Purchase Plan (ESPP) are to motivate and award its employees for their hard work which amounts to salary cost and therefore incurred for the purpose of the business of the taxpayer.
Expenditure incurred for services obtained
Facts of the case
- · The taxpayer, a company of Accenture group, was engaged in providing a range of software development and information technology enabled services. The taxpayer was also engaged in the business of providing co-ordinated consulting business to its clients operating on a global basis.
- · The Accenture group entered into a Cost Contribution Account (CCA) in order to provide seamless and uniform high quality service to their multinational clients. The benefits of CCA would be mutually shared the Accenture Group entities which included the taxpayer.
- · The taxpayer obtained services from various group companies across the world and claimed deduction for payments made in respect of technical services obtained from a group entity in the Netherlands.
- · The Assessing Officer (AO) held that the entire arrangement is adopted by the taxpayer to reduce its income by debiting expenses as technical services received.
Taxpayer’s contentions
- · The taxpayer contended that the expenditure was laid out for services obtained which were wholly and exclusively for the purpose of business. Further, the expenditure was neither in the nature of capital expenditure nor in the nature of personal expenses and therefore deductible under section 37(1) of the Act.
- · The taxpayer also obtained a certificate from the auditors of the Netherlands entity documenting that the amounts recovered from the taxpayer are actual reimbursements of taxpayer’s portion of the costs incurred.
- · The taxpayer further contended that Transfer Pricing Officer (TPO) has held in his order that the international transactions entered into by the taxpayer are at arm’s length price.
Tax department’s contentions
- · The tax department contended that the claim of the taxpayer was not business expenditure and the same was not required for the purpose of business at all.
- · Further, the tax department contended that the type of services rendered against the payment was not explained by the taxpayer.
- · The entire scheme of arrangement is adopted by the taxpayer to reduce its income by debiting expenses in the name of technical services obtained from the Netherlands entity.
Tribunal’s ruling
- · The expression ‘for the purpose of business or profession’ used in Section 37(1) of the Act for allowing expenditure is wide in scope and range. It may include global consistency in business practices, economies of scale, improvements in efficiency and access to the skills and expertise from all parts of global organizations.
- · In the taxpayer’s case, such global arrangement was necessary for the purpose of business and therefore the expenditure incurred for such global arrangement is allowable expenses under section 37(1) of the Act.
- · The payment of expenditure is at arm’s length as determined by the TPO. When an international transaction is determined by the TPO at arms length, it cannot be said that the taxpayer has paid the prices under the said transaction without obtaining any services.
Expenses incurred on Employee Stock Purchase Plan
Facts of the case
- · The taxpayer allotted shares of Accenture Limited (its parent company) to its employees as a part of ESPP. The difference in the market price of the shares of Accenture Ltd and the exercise price of such shares paid by its employees was claimed by the taxpayer as its expenses.
- · The AO disallowed the expenses incurred by the taxpayer on the ground that it was not the expenditure of taxpayer but of its parent company. Therefore the benefit of such expenditure accrues to the parent company and not to the taxpayer.
Tribunal’s ruling
- · The shares were allotted to the employees of the taxpayer and not to the employees of the taxpayer’s parent company.
- · The expenses incurred by the taxpayer were to motivate and award its employees for their hard work amounts to salary cost and accordingly were incurred for the business of the taxpayer.
Our Comments
This is an important decision by the Mumbai Tribunal which reiterates that the expression ‘for the purpose of business or profession’ used in Section 37(1) of the Act for allowing expenditure is wide in scope and range. The decision clarifies the fact that expenditure which is incurred for the purpose of business of the taxpayer should be allowed as a deduction.
