Depreciation should be considered for evaluating operating results of comparables

AMD Research & Development Centre India Pvt. Ltd. Vs DCIT (ITAT Hyderabad)

The method of depreciation adopted by the various comparable companies has an impact on the operating result of the respective comparable companies, which is highlighted in the above charts. The assessee company’s percentage of depreciation to total expenditure is 12.80% whereas the mean of the comparable companies are 5.26%. We notice, there is considerable impact on the operating result. Hence, we agree with the DRP that the depreciation should be considered for evaluating the operating results of the comparables.

FULL TEXT OF THE ITAT JUDGEMENT

The appeal by Revenue and cross appeal by Assessee are against the assessment order passed u/s 143(3) read with section 1 44C(5) of the IT Act, 1961. The appeals pertain to AY 201 0-1 1.

2. Briefly the facts of the case are, AMD Research & Development India Pvt. Ltd., is a company engaged in the business of Research, Design and Development of application solutions for semi conductor products. Assessee is a subsidiary of ATI Canada which is a group company of AMD US. AMD US acquired ATI Canada in 2006, pursuant to which ATI Technologies India Private Limited (ATI Technologies’) changed its name to AMD Research & Development Center India Private Limited (‘AMD R&D’). AMD R&D is engaged in rendering of research, design and development services to ATl Canada in connection with the development of consumer technologies. ATI Technologies has entered into research and development agreement with ATI Canada and ATI Barbados dated April 2005.

2.2 AMD Group was founded on 1^st May 1969 by a group of former Fairchild semiconductor executives. The AMD group began as a manufacturer of logic chips, and entered the RAM chip business in 1975. AMD US is a part of the AMD Group, based out of Sunnyvale, California, United States. AMD US develops computer processors and related technologies for commercial and consumer markets. The main products of AMD US includes microprocessors, motherboard chipsets, embedded processors and graphics processors for servers, workstations and personal computers, and processor technologies for handheld devices, digital television, and game consoles. Some of the platforms and technologies developed by AMD Group are – AMD chipsets: AMD Live; AMD Quad FX Platform; Commercial Platform; Desktop Platforms; Embedded systems; Flash technology and Mobile platforms.

2.3. During the relevant FY, assessee as per 3CEB report, disclosed the following international transactions with it AEs:

1. ATI Technology ULC Canada – Rs. 102,66,46,782

2. Advanced Micro Devices Inc. – Rs. 12,15,09,540

2.4 Financials of the assessee during the FY 2009-10:

1. Operating revenue Rs.114,81,56,322

2. Operating Cost Rs.103,36,55,531

3. Operating profit Rs.11,45,00,791

4. OP/OR (%) 97%

5. OP/OC (%) 11 .07%

2.5 Assessee has taken 16 comparables out of which the Transfer Pricing Officer (TPO) has rejected 9 and accepted six companies as comparables.

2.6 The final comparables selected by TPO with their OP to OC are as under:

S.No.	Name of the comparable company	OP/OC
1	Avani Cimcon Technologies Ltd.	3.39
2	CAT Technologies Ltd.	13.04
3	Comp-U-Learn Tech India Ltd.	19.96
4	E-Infochips Bangalore Ltd.	72.32
5	Evok Tech	18.61
6	E-Zest Solutions Ltd.	22.1
7	Infosys Technologies Ltd.	45.44
8	Kals Information Systems Ltd. (Seg)	22.05
9	Kuliza Tech.	25.92
10	L&T Infotech Ltd.	19.97
11	Mindtree Ltd. (Seg.)	20.47
12	Persistent Systems & Solutions Ltd. (merged)	11.37
13	RS Software (India) Ltd.	9.88
14	Sasken Communication Technologies Ltd.	25.23
15	Tata Elxsi Ltd. (seg.)	17.24
16	Thinksoft Global Services Ltd.	11.22
17	Zylog Systems Ltd.	18.62
18	Persistent Systems Ltd.	31.57
	Total	408.4
	Arithmetic Mean	22.69

2.7 After comparing the average margins of the comparables to the financials of the assessee, the TPO computed the adjusted arm’s length margin as under:

Arm’s Length Margin	22.69%
Less: WCA	(-)1.52%
Adjusted Arm’s length margin	24.21%

2.8 Accordingly, the TPO who passed an order u/s 92CA(3) of the Act on 13/01/2014, recommended adjustment of Rs. 13,78,14,524, which was later rectified u/s 154 to Rs. 13,46,10,192 in respect of international transactions. The same was incorporated by the AO in the draft assessment order. Assessee preferred a petition before the DRP raising various objections.

3. The DRP has given partial relief to assessee as under:

3.1 As far as the comparable companies are concerned, DRP considered the objections of assessee and found that the TPO was not justified in selecting companies like Infosys and L&T Infotech as comparables as the turnover of these companies exceeded more than Rs. 1000 crores. Accordingly, TPO was directed to exclude these two companies from the list of comparables for the purpose of calculating ALP of international transactions. Similarly, DRP has also excluded M/s Mind Tree, as this company had extraordinary events like mergers and acquisitions during the year. By considering the various orders of ITAT, DRP directed TPO to exclude such companies which had extraordinary events like mergers and acquisitions. Accordingly, TPO/AO was directed to exclude the said three companies from the list of comparables finally selected by TPO.

3.2 DRP considered the submissions of assessee as against variable cost of depreciation among various comparable companies vis-à-vis the assessee. Since, assessee estimated the life span of the assets to 3 years and 5 years, depreciation cost risen very high whereas in the comparable cases, it is very less and total average comes to 5.18% whereas the percentage of depreciation to the total cost in the assessee came to 11 .35%. DRP has accepted assessee’s contention by considering the decisions of coordinate benches at Hyderabad, which are listed below:

1. M/s BA Continuum India Pvt. Ltd.

2. Market Tools Research Pvt. Ltd.

3. M/s Qualcore Logic Ltd.

3.3 AO had given effect to the above directions of DRP and arrived at TP adjustment of Rs. 5,72,74,207, which was assessed to tax.

4. Aggrieved with the order of DRP, the revenue is in appeal before us.

5. Grounds raised by revenue are as follows:

“1. In the facts and circumstances of the case, the Hon’ble ORP is not justified in directing the A.O to delete two of the comparable companies without proving how the functional profile of these companies differ With the functional profile of the comparable companies.

2. In the facts and Circumstances of the case, the Hon’ble DRP is not justified in directing the A.O to delete Larsen & tourbo Infotech Ltd companies on the ground of having high turnover which is contrary to Rule 10B(2) which prescribes comparability of international transactions with uncontrolled transactions with reference to functions performed, assets employed and risks assumed.

3. (i) In the facts and circumstances of the case, the Hon’bie DRP was not justified in rejecting M/s. Mindtree Ltd on the mere assumption that acquisition/merger has an impact without proving that it has really impacted the profit margin and how the company became functionally different.

(ii) In the facts and circumstances of the case, the Hon’ble ORP was not justified in rejecting M/s Mindtree Ltd stating that acquisition/merger is an extra-ordinary event ignoring the fact that the company was considered at segmental level and even if the same is considered to be true, still the merger/acquisition does not influence segmental results.

4. (I) In the facts and on the circumstances of the case, the Hon’ble DRP was not justified in directing the TPO to consider PBIT/Cost as the PLI ignoring the fact that software industry being human intensive, the impact of depreciation is insignificant.

(ii) In the facts and on the circumstances of the case, the Hon’ble DRP was not justified in directing the TPO to consider PBIT/Cost as the PLI without proving how the depreciation influenced the margins when the taxpayer is working on Cost plus model.

(iii) In the facts and on the circumstances of the case, the Hon’ble DRP was not justified in directing the TPO to consider PBIT/Cost as the PLI
without appreciating the fact that TNMM is less sensitive to the cost differences and therefore no such adjustments are warranted.

(iv) In the facts and on the circumstances of the case, the Hon’ble DRP was not justified in directing the TPO to consider PBIT/Cost as the PLI without appreciating the fact that eliminating the depreciation on assets like building from the Cost without eliminating the alternative expenditure like rent paid for the building taken on lease from the cost would be prejudicial.”

6. In short, revenue is in appeal before us against allowing the depreciation to be part of variable cost among various comparable companies and direction of DRP to AO for excluding Infosys, L&T and Mindtree as comparables.

7. Ld. DR submitted that DRP is not correct in excluding three companies i.e. L&T, Infosys and Mindtree as the same are functionally comparable.

8. Ld. AR submitted that use of higher turnover filter has an impact on the comparables. He relied on the following case laws:

1. E-gain Communication Pvt. Ltd. (ITAT Pune)

2. Quark Systems Pvt. Ltd., (ITAT Chandigarh)

3. Aginity India Technologies (ITAT Delhi)

4. Deloittee Consulting P. Ltd. (ITAT Hyderabad

5. Genesys Integrating Systems IP Ltd., (ITAT Bangalore)

9. We have heard both the sides and perused the material on record as well as the decisions cited by ld. AR.

9.1 The issue of capping of upper filter has been decided in favour of the assessee in various case laws. For the record, we are quoting below judgment in the case of 24/7 Customer.com (p) Ltd. Vs. DCIT, 158 TTJ (B’lore)94, the tribunal vide para 14.3 has held as under:

“14.3 We have heard both parties, carefully considered the submissions made, judicial decision relied on and the material on record. The Tribunal in the case of Genysys Integrating Systems (India) Pvt. Ltd. (supra) held that only companies within the turnover range ofRs. 1 Crore to Rs.200 Crores should be taken into consideration for the T.P.Study. We are of the considered view that the cited case squarely applies to the assessee^,s case as the turnover of the assessee being approximately Rs. 66 Crores falls within the range of Rs. 1 Crore to Rs.200 Crores. Therefore, respectfully following the decision of the co-ordinate bench of this Tribunal in the case of Genysys Integrating Systems (India) Pvt Ltd. (supra), we direct the Assessing Officer / TPO that only those companies having a turnover ofRs. 1 Crore to Rs.200 Crores be taken as comparable companies and to consequently exclude Wipro BPO Ltd which has a turnover of Rs.322 Crores in the relevant period.”

9.2 In the result, revenue grounds 1, 2 & 3 are dismissed.

9.3 As regards ground No. 4, Ld. AR submitted that depreciation adopted by assessee was at higher side due to the fact that the estimated life of the assets are 3 years and 5 years. The cost of depreciation is high compared to other comparable companies. He submitted that the depreciation shall be excluded from the variable cost of all the comparable companies including assessee to determine the ALP. He relied on the following case laws:

1. BA Continuum India Pvt. Ltd., TS-490-HC-201 4(TELandAP)-TP

2. BA Continuum India Pvt. Ltd., [2013] 40 com311 (Hyd.)

3. Market Tools Research India Pvt. Ltd., [2013] 32 taxmann.com 358 9.4 Ld. AR also submitted the comparative tables on depreciation as below:

Table showing percentage of depreciation to the total expenditure of the comparable companies and the appellant

Sl.No.	Particulars	Depreciation INR in crores	Total expenditure excluding depreciation INR in crores	Percentage of depreciation to total expenditure
		(A)	(B)	(C=A/B)
AMD Research & Development Centre India Pvt. Ltd.		11.59	90.54	12.80%
Comparable companies
1.	Avani Cimcon Technologies Ltd.	0.16	2.74	5.73%
2.	CAT Technologies Ltd.	0.92	7.21	12.80%
3.	Com-U-Learn Tech India Ltd.	0.93	11.93	7.77%
4.	E-Infochips Bangalore	0.79	24.98	3.15%
5.	Evoke Technologies Pvt. Ltd.	0.15	9.16	1.68%
6.	E-Zest Solutions Ltd.	0.38	8.48	4.50%
7.	Kals Information Systems Ltd. (Seg.)	0.10	1.79	5.51%
8.	Kuliza Tech	0.22	7.87	2.78%
9.	Persistent Systems	32.50	386.97	8.40%
10.	Persistent Systems & Solutions Ltd. (merged)	0.24	5.99	3.98%
11	RS Software (India) Ltd.	7.12	147.28	4.83%
12	Sasken Communication Technologies Ltd.	21.29	334.89	6.36%
13	Tata Elxsi Ltd. (segmental)	14.85	288.11	5.15%
14	Thinksoft Global Services Ltd.	1.28	67.04	1.91%
15	Zylog Systems Ltd.	28.42	660.65	4.30%
	Average deprecation rate			5.26%

Table showing depreciation policy of the comparable companies and the appellant

Sl.No.	Particulars	Remarks
A1 E	AMD Research & Development Centre India Pvt. Ltd.	Depreciation at an accelerated rate i.e. higher than the rate prescribed as per Schedule XIV to the Companies Act, 1956.
1.	Avani Cimcon Technologies Ltd.	Depreciation is charged under Written Down Method. Hence not similar.
2.	CAT Technologies Ltd.	Charging of depreciation is different from the assessee. Hence not similar.
3.	Com-U-Learn Tech India Ltd.	Depreciation is charged under Written Down Method. Hence not similar.
4.	E-Infochips Bangalore	Depreciation is charged under Written Down Method. Hence not similar.
5.	Evoke Technologies Pvt. Ltd.	Depreciation is charged under Written Down Method. Hence not similar.
6.	E-Zest Solutions Ltd.	Depreciation is charged under Written Down Method. Hence not similar.
7.	Kals Information Systems Ltd. (Seg.)	Depreciation is charged under Written Down Method. Hence not similar.
8.	Kuliza Technologies Pvt. Ltd.	Charging of depreciation is different from the assessee. Hence not similar.
9.	Persistent Systems	Depreciation policy is similar. However the rates in respect of certain assets are varying form that of AMD.
10.	Persistent Systems & Solutions Ltd. (merged)	Depreciation is at lower rates. Hence not similar.
11	RS Software (India) Ltd.	Rateas as per Schedule XIV to the Companies Act, 1956 (except plant & machinery is depreciated @ 33.33%). Hence not similar.
12	Sasken Communication Technologies Ltd.	Depreciation policy is similar. However the rates in respect of certain assets are varying form that of AMD.
13	Tata Elxsi Ltd. (segmental)	Rateas as per Schedule XIV to the Companies Act, 1956. Hence not similar.
14	Thinksoft Global Services Ltd.	Useful life different in certain assets. Hence not similar.
15	Zylog Systems Ltd.	Depreciation is charged under Written Down Method. Hence not similar.

9.5 In our considered view, the method of depreciation adopted by the various comparable companies has an impact on the operating result of the respective comparable companies, which is highlighted in the above charts. The assessee company’s percentage of depreciation to total expenditure is 12.80% whereas the mean of the comparable companies are 5.26%. We notice, there is considerable impact on the operating result. Hence, we agree with the DRP that the depreciation should be considered for evaluating the operating results of the comparables.

9.6 In the result, revenue ground No. 4 is dismissed.

10. In the result, the revenue appeal is dismissed.

11. Now we deal with the assessee’s appeal.

12. Aggrieved with the order of AO in arriving TP adjustment at Rs. 5,72,74,207 without giving opportunity to assessee for such TP adjustment and finalizing the assessment order, assessee is in appeal before us raising the following grounds of appeal:

“1. On the facts and in the circumstances of the case and in contrary to law, the final assessment order (‘the Order’) issued under section 143(3) read with section (‘r.w.s.’) 144C of the Income-tax Act, 1961 (‘the Act’) by Learned Deputy Commissioner of Income-tax, Circle 1(1), Hyderabad (‘Ld. AO’) dated 19 January 2015 is bad on facts and in law; void-ab-initio, in fructuous and is liable to be quashed as the said order is in violation of section 144C(10) of the Act, in so far, as it is contradictory to and ignorant of the directions issued by the Hon’ble Dispute Resolution Panel (‘DRP’).

2. On the facts and in the circumstances of the case and in contrary to law, the Ld. AO erred in making transfer pricing (‘TP’) adjustment of Rs. 5,72,74,207,the order of the Ld. AO is erroneous to the extent of not incorporating the binding directions of the Hon’ble DRP while finalizing the order under section 143(3) r.w.s. 144C of the Act.

3 Without prejudice to ground no. 1 and 2, the Ld. AO / Learned Transfer Pricing Officer (‘Ld. TPO’) erred on facts and circumstances of the case by not providing the workings for arriving the Arm’s Length Price (‘ALP’) computed by excluding the depreciation cost, as
directed by the Hon ‘ble DRP and thereby raising in fructuous demand in the order passed under section 143(3) r.w.s. 144C.

4. On the facts and in the circumstances of the case and in contrary to law, the Ld. AO / Ld. TPO erred in not granting the benefit of variation of 5 percent while determining the arm’s length price to the Appellant as per the proviso to section 92C(2) of the Act.

5 The Ld. AO has grossly erred on facts and in law by initiating penalty u/s. 271 (1 )(c) of the Act mechanically and without recording any satisfaction for its initiation.

6 Without prejudice to ground no. 1 to 5, the Appellant raises the following grounds of appeal:

6.1 The Ld. AO / Ld. TPO erred and the Hon’ble ORP further erred in upholding the order of the Ld. AO / Ld. TPO in rejecting the detailed and methodical economic analysis undertaken by the Appellant without providing any cogent reasons for the same and without appreciating the fact that the TP documentation and analysis made by the Appellant, was in fact, is in compliance with the provisions of section 92C and 92D of the Act read with Rule 10D of the Income-tax Rules, 1962 (the Rules’) and thereby erred in proposing TP adjustment amounting to INR 13,46,10,192 under section 92CA (3) of the Act, with respect to the international transactions towards providing IT services to its Associated Enterprises.

6.2 The Ld. AO / Ld. TPO erred and the Hon’ble ORP further erred in upholding the order of the Ld. AO / Ld. TPO in calculating the profit margin (net cost plus) of the Appellant by including certain non- operating expenses such as loss on sale of assets and sub-lease expenses, treating the same to be in the nature of operating expenditure.

6.3 The Ld. AO / Ld. TPO erred and the Hon’ble DRP further erred in upholding the order of the Ld. AO / Ld. TPO in conducting the fresh search and the same is liable to be quashed as the companies selected were based on arbitrary filters.

6.4 The Ld. AO / Ld. TPO and the Hon’ble DRP erred on facts in arbitrarily accepting the following comparable companies that were functionally not comparable, have abnormal profits, have peculiar economic circumstances / extraordinary situations, have significant
intangibles, have high on-site development expenditure, have research and development activities, holds significant inventory, as compared to the Appellant:

i) Comp-U-Learn Tech India Limited;

ii) Kals Information Systems Limited;

iii) Sasken Communication Technologies Limited;

iv) Tata Elxsi Limited;

v) Persistent Systems Limited;

vi) E- Infochips Bangalore Limited;

vii) E-Zest Solutions Limited; .

viii) Evoke Technologies Private Limited;

ix) Kuliza Technologies Private Limited;

x) Mindtree Limited

6.5 The Ld. AO / Ld. TPO erred and the Hon’ble DRP further erred in upholding the order of the Ld. AO / Ld. TPO in using non contemporaneous data and substituting the same with Appellant’s analysis and further erred in not considering proviso to Rule 10B( 4) of the Rules by not applying the multiple-year data while computing the margin of comparable companies so selected, on his own conjectures and surmises.

6.6 The Ld. AO / Ld. TPO erred and the Hon’ble ORP further erred in upholding the order of the’ Ld. AO / Ld. TPO in not allowing appropriate adjustments under Rule lOB of the Rules to account for inter-alia, differences in (a) marketing expenditure adjustment (b) research and development expenditure adjustment and (c) risk profile between the Appellant and the comparable companies.”

13. At the time of hearing before us the ld. AR submitted that the assessee is pressing only ground Nos. 3, 4 & 6.4 and 6.4(vi) (i.e. for exclusion of E-Infochips Bangalore Ltd.) as a comparable. Therefore, the other grounds of assessee are dismissed as not pressed.

13.1 The ld. AR submitted that E-Infochips Bangalore Ltd. is functionally different as detailed below:

a) Refer Annual reports of E-Infochips under Significant Accounting Policies, page 1268 of paper book,

“9. The Company is engaged in the development and maintenance of computer software. The production and sales of software cannot be expressed in any generic unit. Hence it is not possible to give the quantitative details of sales and certain other information as required under paragraph 3, 4C and 4D of part-II of Schedule VI to the Companies Act, 1956.”

b) Refer Annual reports of E-Infochips under Significant Accounting Policies, page 1269 of paper book.

“16. Segment Information – Information about primary segments.

The company is primarily engaged in software development and IT enabled services which is considered the only reportable business segment as per Accounting Standard – AS 17 ‘Segment Reporting’ issued by mandatory AS prescribed in Companies (Accounting Standard) Rules, 2006 and the relevant provisions of Companies Act, 1956.

c) Refer profit and loss a/c of E-Infochips at page 1261 of paper Income from software Rs. 430,466,481 Software development expenses Rs. 206,674,788

13.2 With reference to the segment information at page 1269 of paper book (part of annual reports of the company), the company is primarily engaged in software developments and IT enabled services. Whereas assessee is engaged in the business of research, design and development of application solutions for semi conductor services. We find that the company E-Infochips has been held to be functionally not comparable to the assessee.

14. With regard to ground No. 4, of assessee’s cross-appeal, ld. AR submitted that as per section 92C(2) of the Act, assessee is eligible for tolerance margin of 5%.. He has relied on the decision of ITAT, Delhi Bench in case of M/s IHG IT Services (India) Pvt. Ltd. Vs. ITO in ITA No. 5890/Del/2010 wherein the Tribunal held as under:

“13. Coming back to the provisions of the income-tax Act, we are of the opinion that after the retrospective amendment to the second proviso to section 92C(2) by the Finance Act, 2012, there remains no ambiguity that the benefit of tolerance margin is available only when the variation between the arm’s length price as determined under section 92C(1) and the price at which the international transaction has actually been undertaken does not exceed the tolerance margin.

15. Heard both the sides. We are of the view that assessee is eligible for the benefit of tolerance level of 5% while determining ALP.

16. Based on the above discussion on depreciation, exclusion of E-Chips from comparables for arriving at the ALP and eligibility of tolerance level of 5% to be considered for determining the ALP, we direct the AO to consider the above points to determine the ALP.

Accordingly, the AO is directed to complete the assessment u/s 143(3) by determining the taxable income under the Income-tax Act.

17. In the result, assessee’s appeal is allowed.

18. As the corresponding appeal of the assessee in ITA No. 275/Hyd/2015 has been adjudicated by us, the S.A. filed by the assessee becomes infructuous and, therefore, the same is dismissed as infructuous.

19. To sum up, revenue’s appeal in ITA No. 242/Hyd/215 is dismissed and assessee’s appeal in ITA No. 275/Hyd/2015 is allowed for statistical purpose. The S.A. filed by assessee is dismissed.

Pronounced in the open court on 20^th November, 2015