Red Hat India Private Limited Vs DCIT (ITAT Mumbai)
Upon careful consideration we find that assessee has been following consistent system of revenue recognition. The assessee is inter alia engaged in the business of marketing, promotion and sale of ‘Red Hat subscriptions’ to customers in Indian sub-continent to avail support services that are for the open source software system during the subscription period ranging from one to seven year, which is established by the special services agreement or contract. As per the consistent policy of revenue recognition, the assessee accounts for the revenue for service which would be performed in future year in its books as unearned revenue. Assessee’s claim is that this practice by the Assessee in respect of accounting for the sale of subscription is in with Accounting Standard-9 issued by ICAI. In support of this it is submitted that for rendering of service AS-9 provides that revenue should either be recognized on straight line basis over a period in which services are proposed to be rendered. The Assessing Officer has tinkered with this regularly adopted system on the plea that no further services is required to be performed by the assessee, that there is no significant uncertainty existing regarding amount of consideration that will be derived. The Assessing Officer has also find fault with completed contract method claimed to have been followed by the assessee.
Assessee’s contention in this regard is that the assessee never claimed that it is recognizing revenue from subscription under completed service contract method rather it is following the percentage competition method for recognition of Assessee has further reiterated that the assessee has been regularly recognizing revenue over a period to which such subscription relates. It has been claimed that the said practice of recognizing revenue is in accordance with paragraph-7 of percentage complete method of AS-9. The assessee has further placed reliance upon the Income Computation and Disclosure Standard (ICDS) issued by the CBDT pursuant to section 145(2) vide Notification No. 21/2016 dated 29.9.2016 for the proposition that when services arc provided by indeterminate number of acts over a period of specified time. Revenue may be recognized on straight line basis over specified period. The assessee has further relied upon the analogy from recently introduced section 43CB. In the light of the above assessee’s contention is that subscription package agreed may involve various support services which cannot be predetermine. Recipient of service can raise queries numerous times during the tenure of agreement. Similarly, any correction bug fixes etc. can be required by the customers any time during the duration of the agreement. In the light of the above submissions in our considered opinion the Assessing Officer has clearly erred in changing consistently followed method of revenue recognition adopted by the assessee. In the facts and circumstances elaborately dealt with above, we find due merits of the revenue recognition adopted by the assessee which is duly supported by mandate of AS-9 and other parameters referred above.
We also note that it is also a settled law that unless there is change in the facts and circumstances or that it can be said that earlier adopted system was wrong, revenue recognition method cannot be disturbed. We note that such case exists here. In these circumstances, we set aside the order of the Assessing Officer and delete the addition in this regard.
FULL TEXT OF THE ORDER OF ITAT MUMBAI
This appeal by the assessee is directed against the order of the Assessing Officer passed under section 143(3) r.w.s.144C(1) of Income Tax Act, 1961 (hereinafter “the Act”) dated 27.12.2017 for assessment year 2014-15 passed pursuant to the direction of the Dispute Resolution Panel (DRP)-2, Mumbai, dated 27.09.2018.
2. The grounds of appeal read as under :
Transfer Pricing
Adjustment relating to international transaction pertaining to payment of royalty and service fee
1.1 The Ld. AO [along with the Learned Transfer Pricing Officer (‘Ld. TPO’)] under the directions of Hon’ble DRP erred on facts and in law in making adjustment of INR 527,664,612 based on recharacterization of transaction, ignoring the commercial and business aspect, and disregarding the law relating to determination of the arm’s length price under Rule 10B of the Income-tax Rules, 1962 (‘the Rules’)
1.2 The Ld. TPO and Hon’ble DRP erred on facts and in law, in not appreciating the business model followed by the Appellant. In doing so, have grossly erred in:
a) disregarding the ‘License and Service’ Agreement justifying the arm’s length nature of transaction of payment of “Royalty” and ‘Service fees’;
b) misinterpreting the payment of ‘service fees’ as a payment of ‘royalty’ based on its own conjecture and surmises, and ignoring the explanations offered by the Appellant;
c) disregarding the fact that the payment of ‘service fee’ was in connection with the support provided by AE directly to the end customers of the Appellant;
d) disregarding the fact that the Appellant acts as a limited risk distributor and earns assured margins on revenue in ‘Subscription segment’; and
e) disregarding the fact that due withholding taxes were deducted on the service payment made to the AE
1.3 The Ld. TPO and Hon’ble DRP confirming the Ld. TPO’s action erred on facts and in law in disregarding the Transactional Net Margin Method (TNMM) as the most appropriate method for determining the arm’s length price of payment of service fees and applying the ‘Other Method’ in contravention of Rule 10B of the Rules
Adjustment relating to international transactions pertaining to provision of software support services
1.4 On facts and in law, the Ld. AO erred in confirming the Ld. TPO’s action of rejecting Akshay Software Technologies Limited as comparable company despite this comparable being reinstated by the Hon’ble DRP and thereby, violating the provisions of Section 144C(10)of the Act.
1.5 The Ld. TPO and Hon’ble DRP confirming the Ld. TPO’s action erred on facts and in law in determining the arm’s length price for provision of software support services and thereby making an adjustment of INR 12,558,704 to the taxable income of the Appellant. In doing so, have grossly erred in
a) modifying the economic analysis carried out by the Appellant in the Transfer Pricing documentation without providing any cogent reasons;
b) rejecting various comparable companies selected by the Appellant in the Transfer Pricing Documentation and considering various comparable companies as comparable to the Appellant without appreciating that such comparable companies are functionally dissimilar to the Appellant; and
c) disallowing relevant adjustments as per the provisions of Rule 10B(1) and Rule 10B(3)
Adjustment relating to international transactions pertaining to provision of sales & marketing support services
1.6 The Ld. TPO and Hon’ble DRP confirming the Ld. TPO’s action erred on facts and in law in determining the arm’s length price for provision of sales and marketing support services and thereby making an adjustment of 1NR 2,034,038 to the taxable income of the Appellant. In doing so, have grossly erred in
a) modifying the economic analysis carried out by the Appellant in the Transfer Pricing documentation without providing any cogent reasons;
b) rejecting various comparable companies selected by the Appellant in the Transfer Pricing Documentation and considering various comparable companies as comparable to the Appellant without appreciating that such comparable companies are functionally dissimilar to the Appellant; and
c) disallowing relevant adjustments as per the provisions of Rule 10B(1) and Rule 10B(3)
Corporate tax
Additions on account of unearned revenue from subscription services of Rs. 18,54,92,479
2.1 The Ld. AO and Hon’ble DRP erred on facts and in law in making an addition of Rs. 18,54,92,479 pertaining to subscription services and forming part of the ‘unearned revenue’, disclosed in the liabilities side of balance sheet of the Appellant, as income of the current year, without appreciating the fact that the impugned amount is in the nature of advance and is not chargeable to tax in the current year;
2.2 The Ld. AO and Hon’ble DRP, while itself accepting the fact that the Assessee is following percentage completion method of revenue recognition for services as per Accounting Standard -9, issued by ICAI (AS-9), has erred on facts and in law making the addition on the erroneous premise that the completed contract method of revenue recognition is not applicable to the facts of the Assessee;
2.3 The Ld. AO and Hon’ble DRP erred in understanding the nature of services and the contractual framework between the Appellant and its customers and while doing so:
a) erred on facts in holding that the services are complete on entering of the subscription services agreement with the customer, without appreciating that the agreement is for rendering of services for a period which generally exceeds 1 year;
b) erred on facts in equating the income from services with sale of goods based on the incorrect premise that performance of the Appellant is complete on signing of the subscription services agreement; and
c) erred on facts in not appreciating that the Appellant is solely responsible for provision of services during the term of the subscription services agreement.
2.4 The Ld. AO and Hon’ble DRP erred on facts and in law in preponing the income to the current year, without appreciating that the books of accounts are duly audited and unqualified by the auditor, and the said income is offered to tax in the respective year in which it is accounted, thereby, it is revenue neutral;
2.5 Without prejudice to the above, the Ld. AO and Hon’ble DRP erred in not granting a corresponding deduction/relief of 1NR 18,28,95,584 on the preponment of income, for a corresponding increase in expenses in the nature of ‘royalty’ and ‘service fees’ payment as per the terms of the ‘License and Service’ agreement entered into by the Appellant with the AE and in view of the matching concept of accounting;
Other grounds
2.6 The Ld. AO erred in not considering the total income as per the revised return of income filed by the Appellant on 15 March 2016;
2.7 The Ld. AO erred in short granting credit of Taxes Deducted at Source to the extent of Rs. 5,55,907 while computing the tax liability for the year;
2.8 The Ld. AO erred in not granting credit of advance tax paid amounting to Rs. 2,42,00,000 while computing the tax liability for the year;
2.9 The Ld. AO erred on facts and in law in levying the interest under section 234B of the Act;
2.10 The Ld. AO erred on facts and in law in initiating penalty proceedings under section 274 read with section 271(l)(c) of the Act.
The Appellant craves leave to add to, or alter, by deletion, substitution, modification or otherwise, the above grounds of appeal, either before or during the hearing of the appeal.
3. Brief facts and the assessee’s main grievances are summarized in the following submission by assessee.
1.1. Business profile
