Deduction u/s. 10A is allowable without setting off of losses of other units

ITAT BANGALORE BENCH ‘A’

Genisys Integrating System (India) (P.) Ltd.

versus

Deputy Commissioner of Income-tax

IT Appeal No. 908 (Bang.) of 2011
[ASSESSMENT YEAR 2007-08]

JANUARY 29, 2013

ORDER

George George K, Judicial Member

This appeal, at the instance of the assessee, is directed against the assessment order passed under section 143(3) rws 144C of the Act, in pursuance to the direction of the Dispute Resolution Panel (DRP) dated 23.8.2011. The relevant assessment year is 2007-08.

2. Briefly stated, the facts of the case are as follows:-

The assessee is a company. It is engaged in the business of providing software development and IT enable services (Call Centres). The assessee exports the services to the Associated Enterprises (AE) and other clients. During the relevant assessment year, the assessee had entered into international transaction with its AE (as reported in Form No. 3CEB) for software development services and Call Centre amounting to Rs. 15,37,95,126/-. Based on this information in Form No. 3CEB, the Assessing Officer referred the matter under section 92CA of the Act to the Transfer Pricing Officer (TPO) to determine the arm’s length price in relation to the international transaction made by the assessee with its AE. On receiving the reference from the AO, the TPO passed an order under section 92CA on 10/10/2010 determining the adjustment to the arm’s length price of Rs. 1,79,47,930/- in respect of software development services segment. However, no adjustment was suggested in respect of providing of IT enable services (Call Centre). A copy of the TPO’s order as well as Draft Assessment Order was provided to the assessee. The assessee raised various objections before the DRP. The DRP, after going through the TPO’s order, the draft assessment order and after considering the assessee’s submission, upheld the TPO’s adjustments. The Assessing Officer, has, accordingly, incorporated the TPO’s adjustments while determining the total income.

2.1 Aggrieved by the assessment order, the assessee is in appeal before us.

2.2 The assessee has raised 19 grounds in its memorandum of appeal. Ground nos.1 to 16 are regarding the transfer pricing issue. Ground nos.17 to 19 are regarding non-transfer pricing issue.

(I) Transfer Pricing Issue

3. Though the assessee has raised several grounds of appeal regarding the transfer pricing issue, in the course of hearing, the learned AR confined his argument only to ground no.8. Since no argument was advanced on the same, ground nos. 1 to 7 and 9 to 16 are not adjudicated, Ground no. 8 raised in the memorandum of appeal reads as follows:-

The lower authorities (the learned Assessing Officer, learned Transfer Pricing Officer and Hon’ble Dispute Resolution Panel) have erred in rejecting internal comparables selected by the appellant and rejecting transfer pricing analysis of the appellant.

3.1 The factual matrix in regard to the above issue is recapitulated below:-

The assessee had rendered software development services to its AE. The total value of the software development services was Rs. 12,38,48,331/-. The assessee had also rendered software development services to overseas third parties, apart from domestic clients. The assessee adopted transaction net margin method (TNMM) to justify the price charged in the international transaction with its AE. According to the assessee, since adequate data was available with it, the net margin earned from services rendered to its AE was compared with the net margin earned on the services rendered to the non-AE (hereinafter referred to as “Internal TNMM”). The comparables chosen for this exercise where the companies situated outside India to whom the assessee exported software much like the AE to whom also the software had been exported. Based on the comparison of the net margin earned from AE and non-AE (Internal TNMM), the assessee concluded that its transaction with the AE was at arm’s length price.

3.2 The TPO issued show-cause notice dated 21/6/2010 (page 62 to 79 of the paper book filed by the assessee). The notice had proposed re-determining the arm’s length price for the software development services. The notice contained remark on the assessee’s study, new search methodology comparables proposed (28) and the copies of the reply received under section 133(6) from other companies. In reply to the show-cause notice, a detailed reply was filed by the assessee on 6/9/2010 raising various objections to the proposed action of the TPO (the assessee’s reply at page 80 to 646 of the paper book-1 filed by the assessee).

3.2.1 The TPO however rejected the assessee’s objections and selected 26 external companies as comparables. The arithmetical mean was determined at 25.14%. After factoring working capital adjustment of 02.38%, the adjusted arithmetical mean was determined at 22.76%. The TPO determined the transfer pricing adjustment at Rs. 1,79,47,930/-. While computing the arm’s length price, the TPO had aggregated the AE and non-AE transactions. The computation of arm’s length price in the TPO’s order is detailed below:-

“13.6 Computation of Arms Length Price:

The arithmetic mean of the Profit Level indicators is taken as the arms length margin. (Please see Annexure B for details of computation of PLI of the comparables). Based on this, the arms length price of the software development services rendered by the taxpayer to its AE(s) is computed as under:

Arm’s length price :

Price Received vis-à-vis the Arms Length Price:

The price charged by the tax payer to its Associated Enterprises is compared to the Arms Length price as under:

The above shortfall of Rs. 1,79,47,930/- is treated as transfer pricing adjustment under section 92CA.

If any filter or criteria applied by the taxpayer for search of comparables is accepted or any filter or criteria applied by the TPO is relaxed, the entire accept/reject matrix changes resulting in a new comparable set including those companies which are not taken either by the taxpayer or by the TPO in its final comparable set and which may not be finding place in this order. In essence, any disturbance in any one of the criteria of the taxpayer or the TPO results in fresh comparability analysis and the TPO should be given an opportunity if such situation arises”.

3.3 The assessee filed detailed objections with the DRP on 21/1/2011 (pages 647 to 820 of the paper book-I filed by the assessee). Further, additional submissions were made before the DRP on 5/7/2011 (pages 821 to 827 of the paper book-I filed by the assessee). However, the objections raised by the assessee were rejected by the DRP. The Assessing Officer had, accordingly, incorporated the TP adjustments, as suggested by the TPO, while determining the total income.

3.4 Before us, the learned AR filed written submission dated 21/2/2012. The substance of the same is reproduced below for ready reference:-

“During the year under consideration, the appellant rendered software development services to its AE. The appellant also rendered software development services to overseas third parties and domestic clients. The total revenues in the software segment was Rs. 24,18,89,627. This revenue comprised of the following:

During the financial year, the software services rendered to AE were as follows:

The details of exports to third parties (Non-AE) are as follows:

In the case of software services rendered by the appellant to its associated enterprises, the functions performed by the appellant were the same as those performed in the course of provision of software development services to unrelated parties (Non-AEs). Further, the appellant had adequate data so as to enable it determine the net margins for services rendered to its AE as well as Non-AE. Accordingly, “internal” TNMM was selected as the most appropriate method to justify the price charged in the international transactions.

Cost Allocation (Page 82 to 84 of PB-I)

The appellant incurs various costs in rendering software development services. These costs comprises of direct costs, indirect costs and other general administration costs.

The appellant allocated the salary cost (except gratuity and management/support salary) based on the time spent by employees for various segments viz AE exports, Non-AE exports and domestic. Gratuity and management/support salary cost was apportioned based on revenue. The salary of employees engaged in other than software development activities (like finance, admin etc) was allocated based on revenue.

The appellant allocated staff welfare, staff recruitment and training and security and office maintenance expenses based on employee head count. Other expenses where actual were identifiable were booked accordingly. All the other expenses were allocated based on revenue ratio.

PLI and Margin Computation

The appellant adopted operating profit to operating cost as the “Prime Level Indicator” (PLI). The net operating margin on cost of AE and Non AE transactions was as below:

On the basis of the above, the net operating margin on cost of the comparable transaction (non-AE exports) was at 10.01% percent. As the appellant’s operating margin on operating cost in case of controlled transaction was with the arm’s length range provided under the TP Regulations, the transaction between the appellant and its AEs in respect of software development services was justified and considered to be at arm’s length.

In the show cause notice dated 21.06.2010, the TPO had raised doubts about apportionment of salary and other expenses between AE and Non-AE segments. The TPO also raised doubt about functional similarity and billing model between AE and non-AE transactions.

All the queries raised by the TPO were adequately addressed (pages 86 to 95 of PB-I Part 1). In this regard, the appellant submitted agreements, time sheet details, invoices and billing rates relating to AE and Non AE segment on a sample basis for the months of April, October and December (In the Paper Book attached on sample basis due to the voluminous nature). The appellant detailed the functional similarity as well as the methodology of apportionment of expenses.

In the transfer pricing order, there is no discussion about internal TNMM, on the basis of which the appellant had stated that its international transactions were at arm’s length. There is no reason why the internal comparables have not been adopted. The learned TPO has adopted external TNMM and computed the arm’s length price. Large portions of the order u/s 92CA are “borrowed” or “copied” from the orders passed for other software companies (various such examples are detailed on page 657 & 658 of the PB-I Part 2). In the TP Order, the TPO has proceeded as if the appellant had selected external TNMM (refer page of 5 of the TP Order) and had performed a search on Prowess and Capital-line database. Various submissions which were never made by the appellant have been recorded and thereafter rebutted. The Order u/s 92CA appears to be a mechanical exercise. It is a reproduction largely of Orders passed in other cases. In this process, the TPO has overlooked the essence of the comparability exercise undertaken by the appellant. The initial notice from the TPO does refer to the internal TNMM. However, in the final order, there is not even a whisper of the same or about various contentions urged. The Order u/s 92CA has been passed routinely and without application of mind. The order so passed is bad in law and hence liable to be quashed.

The appellant submits that internal comparables are more appropriate and are to be given precedence over external comparables. The computation of arm’s length price in case of TNMM is done as per Rule 10B(1)(e). . The Rules reads as follows:

(e) transactional net margin method, by which,—

(i) the net profit margin realized by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base;

(ii) the net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base;

** ** **

Sub-clause (i) provides that first net profit realized by the enterprise from an international transaction should be computed. Sub-clause (ii) provides that net profit realized from uncontrolled transactions shall be computed. The profit from uncontrolled transactions can be realized by the (1) enterprise or (ii) unrelated enterprise from comparable uncontrolled transaction. The appellant submits that the Rules recognize and accept the adoption of net profit realized by the enterprise from comparable uncontrolled transaction. Such a result should be preferred over net profit realized by unrelated parties from comparable uncontrolled transaction. This is because, such analysis is more meaningful as the relevant data, facts and features of both the segments are available and are more reliable.

The appellant submits relies on the following decisions wherein it has been held that internal comparables are to be preferred:

1. Abhishek Auto Industries Ltd. v. DCIT 2010-TII-54- ITAT-DEL-TP – held that internal CPM is better than external TNMM

2. ACIT v. Schlafhorst Marketing Co Ltd. 13 taxmann.com 104 – held that internal TNMM to be adopted

3. ACIT v. Birla Soft Ltd. 12 taxmann.com 31 – internal TNMM accepted

4. Destination of the World (Subcontinent) (P.) Ltd. v. ACIT 12 taxmann.com 310 – held that preference should be given to internal comparison.

Based on all the above, the appellant submits that internal TNMM as applied by it deserves to be accepted”.

3.4.1 The learned DR on the other hand had given written submissions on 4/7/2012. With regard to ground no. 8, the objections raised by the revenue read as follows:-

“Ground No. 8 : “Rejecting internal comparables selected by the appellant and rejecting transfer pricing analysis of the appellant”

In para-4 of the TP order, the TPO detailed for rejection of comparable selected by the assessee. In the selected comparables, the financial result for the year ending 31/03/2005, 31/03/2006 and 31/03/2007 were considered whereas the TPO applied financial data for F.Y. 2006-07 only. Secondly, the companies engaged in software development were considered as comparable irrespective of verticals horizontals of software services”.

3.4.2 In rebuttal, the assessee submitted as follows:-

“The appellant submits that it had used internal comparable (adopting TNMM as the most appropriate method) to justify the price charged in international transactions. Therefore, the contention of the learned DR that the appellant used data relating to earlier years is without basis”.

3.5 We have heard the rival submissions and perused the materials on record. As rightly pointed out by the learned AR, the internal comparables are more appropriate and are to be given precedence over external comparables. The computation of arm’s length price in case of TNMM is done as per Rule 10B(1)(e). The Rules reads as follows:

“Determination of arm’s length price under section 92C

10B(1) ** ** **

(e) transactional net margin method, by which,—

(i) the net profit margin realized by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base;

(ii) the net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base;

(iii) …………………”

Sub-clause (i) provides that first net profit realized by the enterprise from an international transaction should be computed. Sub clause (ii) provides that net profit realized from uncontrolled transactions shall be computed. The profit from uncontrolled transactions can be realized by the (1) enterprise or (ii) unrelated enterprise from comparable uncontrolled transaction. Thus the Rules recognize and accept the adoption of net profit realized by the enterprise from comparable uncontrolled transaction. Such a result should be preferred over net profit realized by unrelated parties from comparable uncontrolled transaction. This is because, such analysis is more meaningful as the relevant data, facts and features of both the segments are available and are more reliable. On the following decisions, it has been held that internal comparables are to be preferred:-

♦ Abhishek Auto Industries Ltd. v. Dy. CIT [2011] 9 taxmann.com 27 (Delhi) – held that internal CPM is better than external TNMM

♦ Asstt. CIT v. Schlafhorst Marketing Co. Ltd. 47 SOT 120 (Mum.)(URO) – held that internal TNMM to be adopted

♦ Asstt. CIT v Birla Soft Ltd. 46 SOT 437 (Delhi) – internal TNMM accepted

♦ Destination of the World (Subcontinent) (P.) Ltd. v Asstt. CIT 47 SOT 1 (Delhi) – held that preference should be given to internal comparison.

3.6 In the latest order of the Mumbai Tribunal in the case of Tecnimont ICB (P.) Ltd. v. Addl. CIT [2012] 138 ITD 23, the Hon’ble Third Member was considering the following issue on a difference of opinion:-

“Whether in the facts and circumstances of the case, the net margin realized from a transaction with an Associated Enterprise (AE) found and accepted at Arm’s Length Price (ALP) can be taken as a comparable being an internal comparable for computation of (sic-arm) ALP of an international transaction with another AE?”

3.6.1 The Hon’ble Third Member observed that the internal uncontrolled transaction/comparable is to be given preference to the external comparables. The relevant finding of the Hon’ble Tribunal at para 10 reads as follows:-

“10. Clause (i) of Rule 10B(e) stipulates that net profit margin from an international transaction with an AE is computed in relation to cost incurred or sales effected or assets employed etc. Clause (ii) is material for the present purpose. It provides that the net profit margin realized by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base. The ‘base’ of this provision takes one back to clause (i) which refers to cost incurred or sales effected or assets employed or to be employed. On splitting clause (ii) into two parts, it divulges that the reference is made to internal and external comparables. One part of clause (ii) refers to ‘the net profit margin realized by the enterprise…… from a comparable uncontrolled transaction’ and the other part talks of ‘the net profit margin realized ……. by an uncontrolled enterprise from a comparable uncontrolled transaction’. It transpires that whereas the first part refers to the profit margin from internal comparable uncontrolled transactions, the second part refers to profit margin from an external comparable uncontrolled transaction. Thus it is discernible that what is to be compared under this method is profit from a comparable uncontrolled transaction. The word ‘comparable’ may encompass internal comparable or external comparable. There is cue in the rule itself as to preference to be given to internal comparable uncontrolled transactions vis-à-vis externally comparable uncontrolled transactions. It is because the delegated legislature has firstly referred to the net profit margin realized by the enterprise (internal) from a comparable uncontrolled transaction and, thereafter, it points towards net profit margin realized by an unrelated enterprise (external) from a comparable uncontrolled transaction. Thus where potential comparable is available in the shape of an uncontrolled transaction of the same assessee, it is likely to have higher degree of comparability vis-à-vis comparables identified amongst the uncontrolled transactions of third parties. The underlying object behind computing ALP of an international transaction is to find out the profits which such enterprise would have earned if the transaction had been with some third party instead of related party. When the data is available showing profit margin of that enterprise itself from a third party, it is always safe and advisable to have recourse to such internal comparable case. The reason is patent that the various factors having bearing on the quality of output, assets employed, input cost etc. continue to remain by and large same in case of an internal comparable. The effect of difference due to such inherent factors on comparison made with the third parties, gets neutralized when comparison is made with internal comparable. Ex consequenti, it follows that an internal comparable uncontrolled transaction is more noteworthy vis-à-vis its counterpart i.e. external comparable”.

3.6.2 In the instant case, the TPO, in his show-cause notice dated 21/6/2010, proposed to re-determine the arm’s length price for software development services. The TPO had raised doubts about the apportionment of salary and other expenses between the AE and non AE segment. The TPO also raised doubts about the functional dissimilarity and billing models between the AE and non AE transactions. The relevant portion of TPO notice proposing to reject the internal TNMM applied by the assessee reads as follows:

“3. ** ** **

Rejection of TP Document

The taxpayer is rendering software development services to both AE and Non-AE. The taxpayer has compared the services, direct costs, indirect costs and other general administration costs with its Non-AE. The taxpayer has stated that these expenses were incurred for all the segments of the AE, Non-AE and Domestic. The taxpayer has compared the PLI of the AE and Non-AE which is at 5.46% and 6.58% respectively. Based on these assumptions the taxpayer considers the transactions are at Arm’s Length Price. The Internal TNMM applied by the Taxpayer is rejected for the following reasons:-

(i) The nature and services rendered to Non-AE and AE may not be similar. In this regard please produce copies of agreement with Non-AE;

(ii) It is also not known how the salary expenses are apportioned between AE and Non-AE;

(iii) Even the apportionment of Administrative and other expenses like bank charges, depreciation between AE and Non-AE are also not known; In this regard please submit basis on which various heads of expenses are apportioned between AE and Non-AE. Copy of the agreement with AE to be produced.

(iv) It is also not known what is billing methodology of the AE and also that of the Non-AE; Please produce copies of invoices raised with both AEs and Non-AEs to show the billing methodology.

In view of the above, the internal TNMM applied by the taxpayer is rejected and external TNMM is adopted by the TPO …………….”.

3.6.3 All the above queries raised by the TPO was addressed to in the assessee’s reply dated 6/9/2010 (pages 86 to 95 of the paper book-I). We have noticed from the reply furnished by the assessee that it had produced copies of the agreement, time sheet details, invoices and the billing rates relating to the AE and non-AE segments on sample basis in the months of April, October and December. The assessee had also filed detailed functional similarity as well as the methodology of apportionment of expenses. However, we have, further, noticed that in the transfer pricing order, there was no discussion about the internal TNMM, on the basis of which, the assessee had stated that international transactions were at arm’s length. There was no reason as to why the internal comparables have not been adopted.

3.6.4 In the light of the above mentioned orders of the Tribunal and Rule 10B(1)(e)(ii), we direct the Assessing Officer/TPO to adopt the internal TNMM instead of external TNMM. However, the issue is restored to the file of the Assessing Officer/TPO to verify the cost allocation and the PLI and margin computation between the software services rendered by the assessee to its AE vis-à-vis the non-AE and to determine the operative profit/operating cost and the margin thereof and to conclude as to whether the international transaction with that of the AE is within the arm’s length range profit under the TP regulation. It is ordered accordingly.

3.6.5 In the result, ground No. 8 is allowed for statistical purposes.

(II) Non-TP Issue

Deduction under section 10A of the Act

4. During the year under consideration, the assessee company had computed the business loss at Rs.77,58,532/- after claiming deduction of Rs. 61,39,512/- under section 10A of the Act. The Assessing Officer had held that deduction under section 10A is to be allowed from the total income computed after setting off of the loss of other units. After setting off of the loss of other units (non-10A unit), 10A deduction was considered as NIL.

4.1 It was submitted before us that deduction under section 10A is undertaking specific and should be computed without considering the losses of other units (non STP unit). It was stated that the contention of the assessee is supported by the judgment of the Hon’ble High Court of Karnataka in the case of CIT v. Yokogawa India Ltd. [2012] 341 ITR 385.

4.2 The learned DR present was duly heard.

4.3 We have heard the rival submissions and perused the materials on record. The Hon’ble jurisdictional High Court in the case cited supra had categorically held that section 10A is allowable without setting off of losses of the other units. The relevant finding of the Hon’ble jurisdictional High Court at paras 18, 19 & 29 to 31 reads as follows:-

“18. It is after the deduction under Chapter VI-A that the total income of an assessee is arrived at. Chapter VI-A deductions are the last stage of giving effect to all types of deductions permissible under the Act. At the end of this exercise, the total income is arrived at. Total income is thus, a figure arrived at after giving effect to all deductions under the Act. There cannot be any further deduction from the total income as the total income is itself arrived at after all deductions.

19. From the aforesaid discussion it is clear that the income of 10A unit has to be excluded before arriving at the gross total income of the assessee. The income of 10A unit has to be deducted at source itself and not after computing the gross total income. The total income used in the provisions of section 10A in this context means the global income of the assessee and not the total income as defined in section 2(45). Hence, the income eligible for exemption u/s 10A would not enter into computation as the same has to be deducted at source level.

** ** **

29. After making all such computation the assessee would be entitled to the benefit of set off or carry forward of loss as provided u/s 72 of the Act. That is the benefit which is given to the assessee under the Act irrespective of the nature of business which he is carrying on. The said benefit is available even to undertakings u/s 10B of the Act. The expression “deduction of such profits and gains as derived by an undertaking shall be allowed from the total income of the assessee”, has to be understood in the context with which the said provision is inserted in Chapter III of the Act. Sub-section (4) of section 10A clarifies this position. It provides that the profits derived from export of articles or things from computer software shall be the amount which bears to the profits of the business of the undertaking, the same proportion as the export turnover in respect of such articles or things or computer software bears to the total turnover of the business carried on by the undertaking. Therefore, it is clear that though the assessee may be having more than one undertaking for the purpose of section 10A it is the profit derived from export of articles or things or computer software from the business of the undertaking alone that has to be taken into consideration and such profit is not to be included in the total income of the assessee. It is only after the deduction of the said profits and gains, the income of the assessee has to be computed.

30. The provisions of this sub-section will apply even in the case where an assessee has opted out of section 10A by exercising his option under sub-section (8). As discussed, it is permissible for an assessee to opt in and opt out of section 10A. In the year when the assessee has opted out, the normal provisions of the Act would apply. The profits derived by him from the STP undertaking would suffer tax in the normal course subject to various provisions of the Act including those of Chapter VI-A. If in such a year, the assessee has suffered losses, such losses would be subject to inter source and inter head set off. The balance if any thereafter can be carried forward, for being set off against profits of the subsequent assessment years in the normal course. Unabsorbed depreciation also merits a similar treatment.

31. As the income of 10-A unit has to be excluded at source itself before arriving at the gross total income, the loss of non 10-A unit cannot be set off against the income of 10-A unit u/s 72. The loss incurred by the assessee under the head profits and gains of business or profession has to be set off against the profits and gains if any, of any business or profession carried on by such assessee. Therefore as the profits and gains under section 10-A is not be included in the income of the assessee at all, the question of setting off the loss of the assessee of any profits and gains of business against such profits and gains of the undertaking would not arise. Similarly, as per section 72(2), unabsorbed business loss is to be first set off and thereafter unabsorbed depreciation treated as current years depreciation u/s 32(2) is to be set off. As deduction u/s 10A has to be excluded from the total income of the assessee, the question of unabsorbed business loss being set off against such profit and gains of the undertaking would not arise. In that view of the matter, the approach of the assessing authority was quite contrary to the aforesaid statutory provisions and the appellate Commissioner as well as the Tribunal were fully justified in setting aside the said assessment order and granting the benefit of section 10A to be assessee. Hence, the main substantial question of law is answered in favour of the assessees and against the revenue”.

4.4 Following the above judgment of the Hon’ble Court, we hold that deduction under section 10A of the Act is to be allowed prior to setting off of losses of other industrial units, which is a non-STP unit.

4.5 In the result, ground no.17 is allowed.

5. Ground no. 18 is consequential to ground no.17 and hence, this ground is dismissed.

6. Ground no. 19 is with regard to levy of interest under section 234D of the Act.

6.1 Levy of interest under section 234D of the Act is mandatory and consequential in nature. Accordingly ground no.19 is also dismissed.

7. In the result, the assessee’s appeal is partly allowed as indicated above.