Facts of the Case: The Assessee was a wholly owned subsidiary of vCustomer, USA, (an Associated Enterprise-hereafter ‘AE’). The Assessee was engaged in providing voice-based customer care to the AE’s clients. The Assessee renders Call Center services, which fall within the broad description of Information Technology Enables Services (hereafter ‘ITeS’). The Assessee had two units registered under the Software Technology Park Scheme of the Government of India, which were located at New Delhi and Pune. The Assessee was remunerated for the voice call services on cost plus basis. The Assessee explained that the AE undertakes all activities such as marketing and enters into contracts with its customers seeking voice call services. The AE bears all the business risks and the Assessee only acts as an offshore service provider to the customers of the AE. In consideration for the services, the AE remunerates the Assessee by payment of all costs incurred by the Assessee plus a mark up of fifteen percent of the costs.
During the P.Y 2007-08, the Assessee received an amount of Rs. 91,73,94,525/- for voice-based call center services. The Assessee sought to justify the consideration received for the international transactions entered into with the AE to be at ALP. The Assessee submitted a Transfer Pricing Report adopting operating profit margin as the Profit Level Indicator (hereafter ‘PLI’) for the transfer pricing studies. The Assessee applied the Transactional Net Margin Method (hereafter ‘TNMM’), which was considered to be the most appropriate method for the purposes of benchmarking the international transaction. The Assessee’s operating profit margin (i.e. operating profit/total cost) was computed at 14.83% and the Assessee claimed that the same was comparable with other companies rendering voice call services. For the purposes of the transfer pricing study, the Assessee chose eight comparable entities and the arithmetic average of the operating profit margins of the said comparables was computed 15.74%. According to the Assessee, its PLI was within the acceptable range as indicated under the second proviso to Section 92C. The Assessee further claimed that the PLI was liable to be adjusted on account of (i) working capital provided to the Assessee by the AE and (ii) the risks of the business borne by the AE.
The AO referred the matter to the TPO. The TPO, by an order (19th October 2011), computed the TP Adjustment at Rs.11,00,35,400/-. The TPO accepted the method adopted by the Assessee (i.e. TNMM), but rejected the benchmarking report. The TPO also rejected the Assessee’s claim for any adjustment on account of working capital provided to the Assessee and/or risks borne by the AE. The TPO proceeded to identify a different set of comparable companies for the purposes of determining the ALP. The companies selected by the TPO which were considered to be comparables included eClerx and Vishal (subsequently known as Coral Hub Ltd.). The TPO computed the average operating profit margin of the comparable companies at 28.96% on the basis of the average operating profit margin of eleven companies selected by the TPO as comparables for the purposes of benchmarking the international transactions. On the aforesaid basis, the TPO computed the TP Adjustment at Rs.11,00,35,400/-. The AO incorporated the aforesaid adjustment in the draft assessment order passed under Section 144C(1) of the IT Act.
The Assessee objected to the draft assessment order before the DRP. The Assessee impugned the draft assessment order on several grounds including selection of certain companies as comparables and exclusion of other companies considered as appropriate comparables by the Assessee.
The DRP accepted the Assessee’s contention with respect to certain companies, which were considered as comparables by the TPO and directed that the said companies be excluded for the purposes of determining the (i.e. average operating profit margin). However, the Assessee’s contentions with regard to the exclusion of Vishal and eClerx were rejected by the DRP. The DRP held that these companies were also providing Information Technology Enabled Services (ITeS) and, thus, could be used as comparables. Insofar aseClerx is concerned, the DRP held that although there were functional dissimilarities, the same were not significant enough to warrant a rejection of the said company as a comparable. With respect to Vishal, the DRP held that the difference in business model of Vishal would not materially affect the profit margin and thus, there was no infirmity with the TPO’s decision to include the said company as a comparable in its report.
The TPO recomputed the TP Adjustment in terms of the directions issued by the DRP and computed the TP Adjustment at Rs. 5,92,07,428/-. The AO also made certain additions on account of excess deduction claimed under Section 10A of the Act and disallowance under Section 14A of the Act.
The Assessee had preferred appeal before the Tribunal, impugning the assessment order passed by the AO making the Transfer Pricing Adjustments in respect of the AY 2008-09 as finalised by the TPO pursuant to the directions issued by the DRP.
The Assessee filed the present appeal against the order passed by the ITAT. The High Court framed the following questions of law:
Contention of the Assessee: Assessee submitted that eClerx and Vishal could not be considered as comparable entities for the purpose of calculating the benchmark operating profit margin. The Assessee claimed that the said companies were engaged in the business of KPO and, thus, could not be included as comparables for the purposes of benchmarking studies. According to the Assessee, although KPO services were ITeS but the nature of the said services was materially different from the services rendered by the Assessee. It was asserted that eClerx is engaged in financial services in the nature of account reconciliation, trade order management services and has been rated as a leading KPO by Nelso Hall. It was contended that similarly Vishal was engaged in the services of data analytics and providing data processing solutions to some of the largest brands in the world. Vishal too had been rated as a leading KPO by Nelso Hall. In addition, it was pointed out that whilst the employee costs incurred by Vishal was relatively low and constituted only 4.39% of its total cost during the relevant year, the hire charges, vendor payments constituted almost 87% of the total costs. According to the Assessee, this evidenced that Vishal’s business model was different and Vishal had outsourced significant part of its operations. The Assessee submitted that eClerx and Vishal were KPO service providers and could not be considered as comparables for the purposes of benchmarking the Assessee’s international transactions with the AE. The assessee referred to the decision of the Special Bench of the Tribunal in Maersk Global Centers (India) Pvt. Ltd. v. ACIT, ITA 7466/Mum/2012, dated 7th March, 2014 and submitted that the issue of whether Vishal and eClerx could be used as comparables was decided in favour of the Assessee.
Held by DRP: The DRP accepted the Assessee’s contention with respect to certain companies, which were considered as comparables by the TPO and directed that the said companies be excluded for the purposes of determining the (i.e. average operating profit margin). However, the Assessee’s contentions with regard to the exclusion of Vishal and eClerx were rejected by the DRP. The DRP held that these companies were also providing Information Technology Enabled Services (ITeS) and, thus, could be used as comparables. Insofar aseClerx is concerned, the DRP held that although there were functional dissimilarities, the same were not significant enough to warrant a rejection of the said company as a comparable. With respect to Vishal, the DRP held that the difference in business model of Vishal would not materially affect the profit margin and thus, there was no infirmity with the TPO’s decision to include the said company as a comparable in its report.
Held by ITAT: ITAT rejected the Assessee’s contention and held that both eClerx and Vishal were engaged in providing ITeS and once a service fell within that category then no sub-classification of the segment was permissible. The ITAT held that KPO is a term given to the branch of BPO Services where apart from processing of data, knowledge is also applied. The Assessee’s objection that the said two companies had abnormally high profits and thus ought to be excluded as comparables was also rejected.
Held by High Court: High Court did not accept the view taken by ITAT that ‘once a service falls under the category of ITeS, then there is no sub-classification of segment”, as it is contrary to the fundamental rationale of determining ALP by comparing controlled transactions/entities with similar uncontrolled transactions/entities. ITeS encompasses a wide spectrum of services that use Information Technology based delivery. Such services could include rendering highly technical services by qualified technical personnel, involving advanced skills and knowledge, such as engineering, design and support. While, on the other end of the spectrum ITeS would also include voice-based call centers that render routine customer support for their clients. Clearly, characteristics of the service rendered would be dissimilar. Further, both service providers cannot be considered to be functionally similar. Their business environment would be entirely different, the demand and supply for the services would be different, the assets and capital employed would differ, the competence required to operate the two services would be different. Each of the aforesaid factors would have a material bearing on the profitability of the two entities. Treating the said entities to be comparables only for the reason that they use Information Technology for the delivery of their services, would, in our opinion, be erroneous.
The expression ‘BPO’ and ‘KPO’ are, plainly, understood in the sense that whereas, BPO does not necessarily involve advanced skills and knowledge; KPO, on the other hand, would involve employment of advanced skills and knowledge for providing services. Thus, the expression ‘KPO’ in common parlance is used to indicate an ITeS provider providing a completely different nature of service than any other BPO service provider. A KPO service provider would also be functionally different from other BPO service providers, inasmuch as the responsibilities undertaken, the activities performed, the quality of resources employed would be materially different. In the circumstances, we are unable to agree that broadly ITeS sector can be used for selecting comparables without making a conscious selection as to the quality and nature of the content of services. Rule 10B(2)(a) of the Income Tax Rules, 1962 mandates that the comparability of controlled and uncontrolled transactions be judged with reference to service/product characteristics. This factor cannot be undermined by using a broad classification of ITeS which takes within its fold various types of services with completely different content and value. Thus, where the tested party is not a KPO service provider, an entity rendering KPO services cannot be considered as a comparable for the purposes of Transfer Pricing analysis. The perception that a BPO service provider may have the ability to move up the value chain by offering KPO services cannot be a ground for assessing the transactions relating to services rendered by the BPO service provider by benchmarking it with the transactions of KPO services providers. The object is to ascertain the ALP of the service rendered and not of a service (higher in value chain) that may possibly be rendered subsequently.
Applying the aforesaid principles to the facts of the present case, it is once again clear that both Vishal and eClerx could not be taken as comparables for determining the ALP. Vishal and eClerx, both are into KPO Services. In Maersk Global Centers (India) Pvt. Ltd. (supra), the Special Bench of the Tribunal had noted that eClerx is engaged in data analytics, data processing services, pricing analytics, bundling optimization, content operation, sales and marketing support, product data management, revenue management. In addition, eClerx also offered financial services such as real-time capital markets, middle and back-office support, portfolio risk management services and various critical data management services. Clearly, the aforesaid services are not comparable with the services rendered by the Assessee. Further, the functions undertaken (i.e. the activities performed) are also not comparable with the Assessee. In our view, the Tribunal erred in holding that the functions performed by the Assessee were broadly similar to that of eClerx or Vishal. The operating margin of eClerx, thus, could not be included to arrive at an ALP of controlled transactions, which were materially different in its content and value. In Maersk Global Centers (India) Pvt. Ltd. (supra), the Special Bench of the Tribunal had noted the same and had, thus, excluded eClerx as a comparable. It is further observed that the comparability of eClerx had also been examined by the Hyderabad Bench of the Tribunal in M/s Capital Iq Information Systems (India) (P.) Ltd. v. Additional Commissioner of Income-tax (supra), wherein, the Tribunal directed the exclusion of eClerx as a comparable for the reason that it was engaged in providing KPO Services and further that it had also returned supernormal profits.
High Court further observed that even Vishal could not be considered as a comparable, as admittedly, its business model was completely different. Admittedly, Vishal’s expenditure on employment cost during the relevant period was a small fraction of the proportionate cost incurred by the Assessee, apparently, for the reason that most of its work was outsourced to other vendors/service providers. The DRP and the Tribunal erred in brushing aside this vital difference by observing that outsourcing was common in ITeS industry and the same would not have a bearing on profitability. Plainly, a business model where services are rendered by employing own employees and using one’s own infrastructure would have a different cost structure as compared to a business model where services are outsourced. There was no material for the Tribunal to conclude that the outsourcing of services by Vishal would have no bearing on the profitability of the said entity.
Further noted that the Tribunal proceeded on the basis that while applying TNMM method, broad functionality is sufficient and it is not necessary that further effort be taken to find a comparable entity rendering services of similar characteristics as the tested entity. The DRP held that TNMM allows flexibility and tolerance in selection of comparables, as functional dissimilarities are subsumed at net margin levels, as compared to Resale Price Method or Comparable Uncontrolled Price Method and, therefore, the functional dissimilarities pointed out by the Assessee did not warrant rejection of eClerx and Vishal as comparables.
Further, the aforesaid approach would not be apposite. Insofar as identifying comparable transactions/entities is concerned, the same would not differ irrespective of the transfer pricing method adopted. In other words, the comparable transactions/entities must be selected on the basis of similarity with the controlled transaction/entity. Comparability of controlled and uncontrolled transactions has to be judged, inter alia, with reference to comparability factors as indicated under rule 10B(2) of the Income Tax Rules, 1962. Comparability analysis by TNMM method may be less sensitive to certain dissimilarities between the tested party and the comparables. However, that cannot be the consideration for diluting the standards of selecting comparable transactions/entities. A higher product and functional similarity would strengthen the efficacy of the method in ascertaining a reliable ALP. Therefore, as far as possible, the comparables must be selected keeping in view the comparability factors as specified. Wide deviations in PLI must trigger further investigations/analysis.
Consideration for a transaction would reflect the functions performed, the significant activities undertaken, the assets or resources used/consumed, the risks assumed. Thus, comparison of activities undertaken/functions performed is important for determining the comparability between controlled and uncontrolled transactions/entity. It would not be apposite to ignore functional dissimilarity only for the reason that its impact may be reduced on account of using arithmetical mean of the PLI. The DRP had noted that eClerx was functionally dissimilar, but ignored the same relying on an assumption that the functional dissimilarity would be subsumed in the profit margin. As noted, the content of services provided by the Assessee and the entities in question were not similar. In addition, there were also functional dissimilarities between the Assessee and the two entities in question. In our view, these comparability factors could not be ignored by the Tribunal. While using TNMM, the search for comparables may be broadened by including comparables offering services/products which are not entirely similar to the controlled transaction/entity. However, this can be done only if (a) the functions performed by the tested party and the selected comparable entity are similar including the assets used and the risks assumed; and (b) the difference in services/products offered has no material bearing on the profitability.
After examining the facts and circumstances, the High Court decided the case in favour of the assessee by setting aside the order passed by the Tribunal.
Thus, the appeal was allowed.