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 :
