Court: Income Tax Appellate Tribunal
Citation: ACIT Vs. Vedaris Technologies (Pvt.) Ltd. [2010-TII-10-ITAT-DEL-TP]
Brief:- Overview:- The Delhi Bench of Income Tax Appellate Tribunal (“the Tribunal”) in its recent ruling in the case of ACIT v. Vedaris Technologies (Pvt.) Ltd [2010-TII-10-ITAT-DEL-TP] has held that selection of comparable uncontrolled transactions (“comparables”) for determining arm’s length price (“ALP”) should be done with reference to Rule 10C(2) of the Income-tax Rules, 1962 (“the Rules”).
The Tribunal also asserted that under the Transactional Net Margin Method (“TNMM”) appropriate adjustments should be made to account for differences between the controlled and uncontrolled transactions, which could have a material impact on the net profit margin. However, adjustments should not be ad hoc, instead should be supported by facts, documentation and back-up data.
The assessee is a captive software development service provider to its parent company Vedaris U.K. The software was developed on the basis of requirements of the parent company’s customers, to whom the assessee also provided after sales services in relation to the software. The assessee was being remunerated on the basis of a man-day rate. The assessee claimed that the value of transactions was based on a cost plus method, although the assessee did not provide any documentation or evidence to either justify the man-day rate or support the cost plus methodology.
In the absence of any documentation supporting the determination of the ALP, the Transfer Pricing Officer (“TPO”) concluded that TNMM was the most appropriate method, and carried out a search for com parables.
The TPO selected 20 comparable companies with average net margin of 16.585%, as against the net margin of 7.78% earned by the assessee. An adjustment was made by the TPO for the difference after allowing a deduction of 5% as per proviso to section 92C(2) of the Income-tax Act, 1961 (“the Act”).
In appeal before the Commissioner of Income-tax (Appeals) (“CIT(A)”), the assessee objected to the selection of the 20 comparable on various grounds. After analyzing the comparable companies’ details, the CIT(A) rejected 15 companies and concluded that only the remaining five were valid comparable. The rejection of the 15 companies was based on criteria such as related party transactions, functionality and turnover quantum. Based on the five comparable, the CIT(A) determined the ALP at 16.42%. However, the CIT(A) neither allowed any adjustment nor did he allow the benefit of 5% provided in the proviso to section 92C(2) of the Act.
Before the Tribunal
The assessee appealed before the Tribunal to reject two companies out of the set of five comparables selected by the CIT(A). The assessee also claimed adjustment on account of working capital, risk, and research and development.
The Departmental Representative (“DR”) appealed before the Tribunal to reject another two companies out of the final set of five companies selected by CIT(A), and to also select an additional company not considered by the CIT(A).
In effect, out of the five comparable companies selected by the CIT(A), only one comparable was acceptable to both the assessee as well as the DR.
The selection of TNMM as the most appropriate method was not a subject matter of dispute before the Tribunal, and was also acceptable to the Tribunal.
As regards the comparable companies, the Tribunal considered the submissions of the assessee and the DR, and analyzed in detail the annual accounts of the four disputed companies and the one additional company proposed by the DR. The Tribunal held that none of the five (four disputed plus one additional) companies were comparable. The rejection was on account of various factors such as differences in functionality, business models, markets being catered to (i.e., domestic vis-à-vis exports), domains being served, etc.
Accordingly, only one company was left, which was selected as the comparable, and which had a net profit margin of 12.86%.
With regard to the working capital adjustment claimed by the assessee, the Tribunal held that funds received in advance without stipulation of interest may have an impact on the net profit margin, for which an adjustment may be appropriate. Accordingly, the matter was restored back to the AO to consider and decide. Furthermore, as regards the adjustment on account of risk, the Tribunal held that by providing after sales service, the assessee was, in effect, bearing the risk of software development. The Tribunal also held that an adjustment on account of risk is not feasible without an examination of the contractual terms of the relevant transaction, which lay down explicitly or implicitly the division of responsibilities, risks, and benefits, between the parties to the contract.
The Tribunal also disregarded the claim for an adjustment on account of R&D, made on an ad hoc basis without any back-up data or a firm calculation.
In addition, the Tribunal also denied the benefit of 5% provided in the proviso to section 92C(2) of the Act, on the grounds that this proviso was applicable only when more than one price is determined by the appropriate method, which was not so in the current case, as the ALP was determined on the basis of a single comparable.
This case re- emphasizes the significance of analyzing functions, operating business models, risks, market related factors and conditions, scale of operations, etc., while evaluating and selecting comparable.
In addition, the Tribunal reiterated the need for documentary evidence and back-up data to substantiate any aspect of a transfer pricing analysis whether it is the basis of determining a transfer price or making an adjustment or selecting a transfer pricing methodology, etc.