TPO must justify arm’s length margin fixed by it

IN THE ITAT MUMBAI BENCH ‘K’

SITEL India (P.) Ltd.

Versus

Assistant Commissioner of Income-tax

IT Appeal Nos. 3535 & 4073 (Mum.) of 2009

[Assessment year 2004-05]

DECEMBER 5, 2012

ORDER

1. These are cross appeals by Assessee and Revenue against the order of the CIT (A)-32 Mumbai dated 27.02.2009. Assessee has raised five grounds in its appeal, whereas the Revenue has raised only one ground in its appeal. Assessee’s ground No.2 and Revenue’s appeal are with reference to the transfer pricing adjustment made by the TPO which was partly confirmed by the CIT (A). The rest of the grounds are on other issues on assessment of total income.

2. We have considered the arguments of the learned Counsel Shri Sunil M Lala and the learned CIT (DR) Shri Ajeet Kumar Jain and their arguments were incorporated wherever required. First we will take up assessee’s appeal in ITA No.3535/Mum/2009.

3. Ground No.1 is general in nature which does not require any adjudication.

4. Ground No.2 is with reference to the transfer pricing. The Revenue ground is also on the same issue. Both the grounds of assessee and the Revenue are as under:

Assessee’s Ground No.2:

“Transfer Pricing: The learned CIT (A) erred on facts and in law by allowing only partial relief to the adjustments made by AO in relation to transfer pricing matters. The Appellant therefore, prays that the adjustments in relation to transfer pricing matters made by the CIT (A) be deleted”.

Revenue’s Ground:

“On the facts and in the circumstances of. the case and in law, the learned CIT (A) erred in deleting the addition made by AO on the basis of working provided by the TPO where the operating margin was taken at 11.96% instead of 9.47% taken by assessee without appreciating the facts of the case. The appellant prays that the order of the CIT (A) on the above ground be set aside and that of the ITO/ACIT/DCIT be restored”.

5. Briefly stated, assessee is a domestic company formed by a shareholding between Sitel Group & TATA group with 50% stake each. Assessee has provided software development services to its overseas enterprise. Assessee in the TP study used TNM method to benchmark its ALP for its transaction with AE and has computed the profit margin of com parables and compared with its own margins. While calculating the operating profit margins the assessee has excluded the idle capacity cost. Since no basis has been provided by the assessee as to why the same has been excluded, the TPO did not allow the idle capacity cost and on the basis of the OP margin of the com parables provided by assessee, fixed the arm’s length margin at 11.96% on the operating cost of Rs. 55,82,69,000 and accordingly arms length price was arrived at Rs. 6,67,88,000. Assessee’s margin and cost was less, adjustment of amount of Rs. 5,11,22,000 was made for the impugned assessment year. AO having regard to the order of the TPO made the said addition in the assessment.

6. Before the CIT (A), assessee has raised many objections, though first objection is with reference to arriving at the operating margin of 11.96%. The comparable arm’s length range is from (-) 6.04% to 19.02% of operating margins with arithmetic mean 9.47% in respect of the comparable instances. There is no discussion in the assessment order or in the order of the TPO as to why and how the operating margin of 11.96% was arrived at. It was also the contention before the CIT (A) that assessee is a provider of software development services and is basically engaged in providing contract center services in the form of voice, web chat and email. It was further submitted that there is average reduction in operating profit earned by assessee as there was reduction of gross revenue earned during the year on account of withdrawal of substantial business by its major client. Similarly increase in the number of employees as a strategic method to develop its business in the long run and therefore, assessee has provided idle cost adjustment to make it comparable with the other companies. It was also further submitted that assessee was 50:50 joint venture between the SITEL Netherlands and Tata Group (comprising of Tata Info Tech Limited holding 40% and Tata International Limited holding 10%). Therefore, since controlling interest was held by the third party, there is no need for any arms length adjustment. Further it was submitted that assessee’s profits were totally exempt under section 10A, therefore, shifting of profits does not arise. In the course of appellate proceedings, assessee also furnished additional evidence of the gross revenue earned by the AEs from the contract executed with the end customers. It was the submission of assessee that the AEs retained part of the revenues varying from 0 to 26% and passed on the balance to assessee. Therefore, adjustment so proposed by the TPO does not arise.

7. The learned CIT (A) discussed these objections elaborately vide Para 3 of the order item-wise and vide Para 3.11 to 3.13 decided the issue as under:

“3.11. I have perused the order of the TPO and considered all the above submissions/contentions of the Appellant. I have also perused the remand report received from the AO vide letter dated 11.06.2007 and another report dated 27.02.2008 received from TPO. At the outset, the Appellant has prayed for admission of additional evidence on the above grounds relating to transfer pricing adjustment. I have perused the additional evidence filed by the Appellant and find it appropriate to take cognizance of the same and accept it under Rule 46A, as the appellant did not have sufficient opportunity during the course of the assessment proceedings to produce the above documentary evidence. Looking at the evidence received from the AEs providing details of revenue, costs, profit/loss margin earned by the AEs, it is clear that the AEs have retained an amount of Rs 54,389,700, representing 0% to 26% of the gross revenue earned from the end customers for various projects. The Table below shows the project-wise profitability for the AEs for the year:

From the above, it is clear that in case of projects resulting in loss situation to the AEs, there cannot be any adjustment of arm’s length price in the case of the Appellant.

3.12 However, it is also observed that there are certain projects wherein the AEs have retained substantial profits in relation to their marketing services. Given the fact that AEs are only working on a limited portion of the projects, the AEs could have been compensated on each of the projects on a cost plus arrangement. As the AEs are located in US and UK, the arm’s length profit margin for such services generally ranges from 5% to 7% (even OEED guidelines suggest so), depending on facts and circumstances of the each case. In view of the above, I consider profit margin of 6% to be an appropriate arm’s length consideration for the efforts of the AEs. Project-wise details where AEs have earned more than 6% margin and the amount of excess margin earned by the AEs is as under:

3.13. Based on the above, the adjustment in the case of the Appellant is required to be restricted to Rs. 5,456,479/-. Accordingly the appellant is given a relief to the extent of Rs. 45,665,521/- (Rs. 51,122,000/- less Rs. 5,456,479/-). In view of the above the issue relating to transfer pricing adjustment (Ground No.2 to 11 is partly being allowed”.

8. Assessee is objecting to the above confirmation of Rs. 54,56,479 whereas the Revenue is aggrieved on the reduction made by the CIT (A). The learned Counsel referred to the submissions made before the CIT (A) and also the orders passed by the authorities in later years wherein assessee’s margin were accepted without any adjustment. On the principles of consistency it was submitted that the same approach should be made for this year also. It was one of the argument that the additions proposed cannot be exceeded the profit earned by the AE as assessee is a contact service contractor and the gross receipts are accounted by the PE. In this regard assessee’s Counsel submitted a note with reference to ‘having regard to” used in section and submitted that as AE made losses the addition cannot be exceeded the ultimate profits earned in the whole transactions with third parties. The learned Counsel also made detailed submission on the object of TP provisions, determination of ALPs to contend that the method/formula cannot be accepted which gives absurd result in the TP adjustments. He also referred to the TPO order for 2006-07 wherein all profits and costs have been accepted. In assessment year 2005-06 when the adjustments were proposed assessee could not give details as they were lost due to floods and the TP adjustments were accepted. It was the submission that in assessment year 2004-05 when assessee has furnished entire data regarding profits earned by the SITEL US, the CIT (A) erred in selecting only two profit making companies, ignoring the losses and determining the ALP margin at 6%, therefore, confirming the amount of Rs. 54,56,479.

9. The learned CIT (DR) submitted that the TP study submitted by the assessee did not contain any data and referred to the page 34 of the TP study report. He then referred to Rule 10B for internal comparable and external com parables. In order to claim idle capacity adjustment, the onus is on assessee which has not been discharged. The learned DR submitted the arguments with regard to methods prescribed under the provisions to submit that assessee has adopted TNM as a method for TP study and therefore, the arms length margin arrived at by the TPO should be upheld and there is no basis for CIT (A) to reject the additions so proposed by the TPO.

10. We have considered the detailed submissions made along with the various case law relied upon by the Counsels. What we notice from the order of the CIT (A) is that he has not only shifted the method adopted by assessee and the TPO, but also changed the “tested party”. Assessee has made TNMM study and in comparison with the profits earned by the comparable, assessee bench marked itself and claimed idle capacity as it has lost a major contract during the year so as to justify the profits earned by it during the year. The TPO while rejecting the idle capacity, however, did not discuss anything about the arms length margin fixed at 11.96% determining the TP order. In fact the order is so brief the same can be extracted as under:

“3. Assessee has provided software services to its overseas enterprises. In this connection, assessee has used TNM method when it has computed the margin of com parables and are the same with its own margin. While calculating the margin for assessee, it has excluded idle capacity cost. However, no basis has been provided as to why the same is excluded. As third party software developer would never bear the idle capacity cost there is no merit on reducing the idle capacity cost while computing the margin. In this regard assessee was asked to show cause as to why the idle capacity cost should not be disallowed and the margin of comparable of 11.96% be not considered to determine the arms length price for this transaction.

Assessee has only reiterated what was stated in the earlier submissions that the idle capacity is not operating cost and hence the same is excluded. The submission of assessee is not accepted because third party software developer would not bear such cost in the course of business. Moreover, no such idle capacity adjustments have been made while arriving at the margins of the comparable companies.

Accordingly an adjustment is being made to this transaction on the following basis:

11. This indicates that assessee’s TP study has not been considered by the TPO. Vide Annexure- D to the TP study assessee has selected ten comparable companies and summary of net cost + margin varies from -6.04% to 19.06%. Mean arrived at assessee’s TP study was at 9.47%. How this amount was rejected and why it is fixed at 11.96% could not be discerned from the order of the TPO, as it is very brief without any discussion. Further when assessee raised arguments on various issues and submitted that the total profits earned by the AEs and assessee put together and furnished the information how the profits are apportioned between the AE and assessee, the CIT (A) shifted tested party from assessee to AE and that too only two AEs were accepted in which there were profits, ignoring the AEs which incurred losses on various projects. Even after considering the profit companies, the CIT (A) arbitrarily fixed the margin at 6% without there being any basis and arrived at the TP adjustment restricting to Rs. 54,56,479. Therefore, neither the TPO’s order can be considered as appropriate nor the order of the CIT (A) on the given facts of the case.

12. It is also placed before us that assessee’s TP study in later years were accepted without any adjustment and so adjustment in this year should be deleted. However, the reasons for accepting the TP study in later years could not be examined by us with the TP study made in this year. As stated above, even though the method of TNM was accepted, the CIT (A) went by profit split method and further restricted to two AEs by shifting the tested party from assessee to AE. In view of this, we are of the opinion that the matter should be restored to AO for fresh consideration by the TPO. For this purpose, we set aside the order of the CIT (A) and the order of the TPO/AO with a direction to reconsider the arms length margin keeping in mind the objections of assessee raised before the CIT (A) and also the other aspects before deciding the issue. TPO should give due opportunity to assessee and also decide whether assessee’s com parables are to be accepted or not and if it is not accepted the reasons should be specified by undertaking a proper FAR analysis. In case the TPO accept assessee’s Transfer pricing study in later years those can also be kept in mind while determining the issue in this year.

13. The learned Counsel and the learned CIT (DR) gave elaborate submissions with reference to various propositions on the issue. Since we are of the opinion that the TP order itself was not correctly made and the CIT (A) also deviated from the norms, we are of the opinion that there is no need to consider and adjudicate on the various propositions. Since the issue is restored to AO, assessee is free to raise various objections before the TPO in the re-assessment proceedings.

14. In the result assessee’s grounds as well as Revenue ground on this issue are considered allowed for statistical purposes. The matter is restored to AO for fresh consideration.

15. Ground No.3. Assessee’s ground is as under:

“3. Treatment of interest on term deposit receipts and miscellaneous income: Based on the facts of the case and in law, the learned CIT (A) erred in upholding the action of AO in treating interest earned on term deposit receipts and miscellaneous income as income from other sources instead of business income. The appellant therefore prays that the amount of Rs. 78,70,769 towards interests earned on term deposit receipts and Rs. 31,745 as miscellaneous income should be considered as part of net profits earned in business while computing deduction under section 10A of the Act and AO be directed to compute the deduction accordingly”.

16. It was fairly admitted that this issue is decided against assessee by the order of the ITAT Mumbai in ITA Nos. 6395/Mum/05 & 3110/Mum/08 in assessment years 2002-03 and 2003-04. The findings of the ITAT vide para 8, 9 & 10 are as under:

“8 It is to be noted that the jurisdictional High Court has followed the decision of the Divisional Bench in the case of Alfa Laval India Ltd v. DCIT reported in 133 Taxman 740(Bom). In the case of Alfa Laval India Ltd (supra), the interest income was received by the assessee from the customers and in those facts, it was held that the interest income was eligible for deduction u/s 80HHC. As it is held by the Hon’ble High Court and otherwise there is no dispute that the interest from the customers is part and parcel of the sale receipts and therefore, the same is assessable under the head ‘profits and gains of the business or profession. Similarly, in the case of Sociedade de Fomento Industrial Ltd (supra), the various deposits by the assessee was treated as part of business activity and therefore, the interest income was held as part of business profit.

9 In the case in hand, undisputedly the assessee is not in regular business of lacing various deposits and therefore, the interest income has no direct or live connection with the business undertaking of the assessee and particularly, the export articles or things and computer software. The decision relied upon by the learned AR of the assessee are on the facts when the interest earned on the deposits made in connection with the business of the assessee. Therefore, in view of the decision of the Hon’ble Supreme Court in the case of Liberty India (supra), the receipts should come within first degree of source as to fall under the words ‘derived from’. The Hon’ble Supreme Court has observed in para 14 as under:

“14 Analyzing Chapter VI-A, we find that section 80-IB/80-IA are a code by themselves as they contain both substantive as well as procedural provisions. Therefore, we need to examine what these provisions prescribe for “computation of profits of the eligible business”. It is evident that section 80-IB provides for allowing of deduction in respect of profits and gains derived from the eligible business. The words “derived from” are arrower in connotation as compared to the words “attributable to”. In other words, by using the expression “derived from”, Parliament intended to cover sources not beyond the first degree. In the present batch of cases, the controversy which arises for determination is: whether the DEPB credit/duty drawback receipt comes within the first degree sources? According to the assessee(s), DEPB credit/duty drawback receipt reduces the value of purchases (cost neutralization), hence, it comes within first degree source as it increases the net profit proportionately. On the other hand, according to the Department, DEPB credit/duty drawback receipts do not come within first degree source as the said incentives flow from the incentive schemes enacted by the Government of India or from section 75 of the Customs Act, 1962. Hence, according to the Department, in the present cases, the first degree source is the incentive scheme/provisions of the Customs Act. In this connection, the Department places heavy reliance on the judgment of this court in Sterling Foods [1999] 237 ITR 579. Therefore, in the present cases, in which we are required to examine the eligible business of an industrial undertaking, we need to trace the source of the profits to manufacture. (see CIT v. Kirloskar Oil Engines Ltd. reported in [1986] 157 ITR 762.)”

10 Thus, in view of the decision of the Hon’ble Supreme Court in the case of Liberty India (supra), we hold that interest earned by the assessee on surplus funds deposit in the bank does not come under the first degree of source of profit derived from profit of business of undertaking. Accordingly, this issue is decided against assessee”.

17. Since the facts are similar, respectfully following the Coordinate Bench decision the order of the CIT (A) is upheld and assessee’s ground is rejected.

18. Ground No.4. Assessee’s ground is as under:

“4. Deduction under section 10A of the Act:

On the facts and in the circumstances of the case the learned CIT (A) erred in upholding the action of AO in denying the reduction of communication line expenses from the total turnover while accepting the reduction from export turnover for the purpose of computing the deduction under section 10A.

The Appellant prays that AO be directed to reduce the amount of communication expenses from the total turnover while computing the deduction under section 10A of the Act”.

19. The issue relating to the ground is with reference to the basis of computing the deduction under section 10A of the Income Tax Act. Assessee incurred communication line expenses in foreign exchange of Rs. 7,01,67,886 for transferring the data in the year under consideration. As assessee makes gross billing and the amounts are received from the AEs after deducting the communication expenses. Assessee has reduced this amount from the export turnover as well as total turnover while computing the deduction under section 10A of the Act. AO however, did not accept the reduction of communication line expenses from the total turnover while accepting the reduction from export turnover based on the definition of ‘export turnover’ given under the provisions. Assessee’s contentions and reliance on the decisions of Gate Global Solutions Ltd. v. Asstt. CIT [2008] 24 SOT 3 (Bang) (URO), Indo Fuji Information Technologies (P) Ltd v. ITO [IT Appeal Nos. 376 & 377 (Bang.) of 2007] and Patni Telecom (P) Ltd. v. ITO [2006] 22 SOT 26 (Hyd.) have not been accepted by the CIT (A) on the reason that they are distinguishable or not binding. Assessee is aggrieved.

20. At the outset it was submitted that this issue was decided by the Chennai Special Bench of the ITAT in the case of ITO v. Sak Soft Ltd. [2009] 30 SOT 55 wherein it was held that for the purpose of applying formula under section 10B(4), the freight, telecom charges or insurance attributable to delivery of articles or things or computer software outside India or the expenses, if any, incurred in foreign exchange in providing the technical services outside India are to be excluded both from the export turnover and from the total turnover, which are the numerator and the denominator, respectively, in the formula. The learned Counsel also relied on the decision of the Hon’ble High Court in the case of CIT v. Tata Elxis Ltd, [2012] 204 Taxman 321 and jurisdictional High Court in the case of CIT v. Gem Plus Jewellery India Ltd. [2011] 330 ITR 175. The learned DR however, relied on the orders of AO and the CIT (A) on this issue.

21. We have considered the issue and the rival contentions. As far as definition of export turnover is concerned, AO has correctly excluded the communication line charges as per the provisions of the Act. Since the total turnover is not defined in the Act, this issue has been contested and the ITAT Chennai Special Bench in the case of Sak Soft Ltd’s case (supra) has decided the issue as under:

“Exemption under section 10B: Computation of total turnover-Expenses attributable to delivery of computer software outside India-As per cl, (iii) of Expln. 2 to s. 10B, freight, telecom charges and insurance attributable to delivery of goods outside India and expenses incurred in foreign exchange in providing technical services outside India have to be excluded from export turnover-On the basis of parity principle, same have to be excluded also from the total turnover though that expression has not been defined in the section-Element of turnover is missing in these receipts and receipts are received by the assessee only as reimbursement of expenses incurred by it-Secondly, the definition of export turnover contemplates that the amount received by the assessee in convertible. Foreign exchange should represent “consideration” in respect of the export-Any reimbursement of the items of expenses mentioned in the definition can under no circumstances be considered to represent “consideration” for the export-Thus, the expression ‘total turnover’ should also be interpreted in the same manner and the said items of expenses cannot form part of total turnover-Expression ‘total turnover’ as defined in ss. 80HHE and 80HHF excludes freight, telecom charges, etc and expenses incurred in foreign exchange in providing technical services outside India-Statutorily parity is maintained between export turnover and total turnover in these sections- Hence, there is no reason why such parity cannot be maintained between export turnover and total turnover in section 10B-Words ‘total turnover’ appearing in various provisions of the Act should be construed in the same manner unless it leads to contextual inconsistencies or repugnancy- Therefore for the purpose of applying the formula under sub-sec. (4) of section 10B, the freight, telecom charges or insurance attributable to deliver articles or things or computer software outside India or the expenses, if any, incurred in foreign exchange In providing the technical services outside India are to be excluded both from the export turnover and from the total turnover, which are the numerator and the denominator respectively In he formula”.

22. Not only that, this issue is also covered by the decision of the jurisdictional High Court in the case of CIT v. Gem Plus Jewellery India Ltd (supra) given in the context of section 10A with reference to freight & insurance. The decision of the Hon’ble Bombay High Court is as under:

“Under sub-section (1) of section 10A of the Income-tax Act, 1961, a deduction is allowed from the total income of the assessee of such profits and gains as are derived by an undertaking from the export of articles or things or computer software for a period of ten consecutive assessment years commencing from the assessment year relevant to the previous year in which the undertaking begins manufacture or production. Sub-section (4) of section 10A provides the manner in which the profits derived from the export of articles or things or computer software shall be computed. Under sub-section (4) the proportion between the export turnover in respect of the articles or things, or, as the case may be, computer software exported, to the total turnover of the business carried over by the undertaking is applied to the profits of the business of the undertaking in computing the profits derived from export. In other words, the profits of the business of the undertaking are multiplied by the export turnover in respect of the articles, things or, as the case may be, computer software and divided by the total turnover of the business carried on by the undertaking. The expression “total turnover” has not been defined at all by Parliament for the purposes of section 10A. However, the expression “export turnover” has been defined. The definition of “export turnover” excludes freight and insurance. Since export turnover has been defined by Parliament and there is a specific exclusion of freight and insurance, the expression “export turnover” cannot have a different meaning when it forms a constituent part of the total turnover for the purposes of the application of the formula. A construction of a statutory provision which would lead to an absurdity must be avoided. Moreover, a receipt such as freight and insurance which does not have any element of profit cannot be included in the total turnover. Freight and insurance do not have an element of turnover. For this reason in addition, these two items would have to be excluded from the total turnover particularly in the absence of a legislative prescription to the contrary.

Held, (i) that interest income could not be taken as business income and could not be taken into account in computing the special deduction under section 80HHC. CIT v. Asian Star Co. Ltd. [2010] 326 ITR 56 (Bom) followed.

(ii) That gross interest should be taken into account for purposes of exclusion under clause (baa) of the Explanation to section 80HHC.

(iii) That the foreign exchange was realized by the assessee within the period stipulated in law. The assessee had realized a larger amount in terms of Indian rupees as a result of a foreign exchange fluctuation that took place in the course of the export transaction. The gains had to be taken into account for the purpose of section 10A.

CIT v. Shah Originals [2010] 327 ITR 19 (Bom) distinguished.

(iv) That it was an admitted position that the assessee had deposited both the employer’s and the employees’ contribution towards provident fund and ESIC, though beyond the due date including the grace period. The Assessing Officer added these payments to the total income of the assessee. The dis allowance which was effected by the Assessing Officer had not been challenged by the assessee. The plain consequence of the dis allowance and the add back that had been made by the Assessing Officer was an increase in the business profits of the assessee. The contention of the Revenue that in computing the deduction under section 10A the addition made on account of the dis allowance of the provident fund/ESIC payments ought to be ignored could not be accepted. No statutory provision to that effect having been made, the plain consequence of the dis allowance made by the Assessing Officer must follow. The Tribunal was justified in directing the Assessing Officer to grant the exemption under section 10A of the Act on the assessed income, which was enhanced due to dis allowance of the employer’s as well as employees’ contribution towards PF/ESIC.

23. The principle laid down in the above decision is that whatever is excluded from the export turnover has to be excluded from the total turnover also while computing the deduction under section 10A. In view of this, AO is directed to exclude the communication line charges from the total turnover as well. Ground is allowed.

24. Ground No.5 is with reference to software expenses. The ground is as under:

“5. Software Expenses:

On the facts and in the circumstances of the case, the learned CIT (A0 erred in upholding the action of AO in disallowing the software expenditure of Rs. 38,85,928 incurred by the Appellant by treating the same as capital expenditure instead of revenue expenditure. The appellant therefore, prays that the additions made by AO I this regard is not justified and be deleted”.

25. During the course of the argument, the learned Counsel did not press this ground. Accordingly treated as withdrawn.

26. In the result appeal filed by assessee is considered ‘partly allowed’ for statistical purposes and the Revenue’s appeal is considered’ allowed’ for statistical purposes.