The Delhi bench of the Income Tax Appellate Tribunal (Tribunal) recently pronounced its ruling in the case of Birlasoft (India) Ltd. Vs. Dy. CIT ITA No. 3839/DEL/2010, where the Taxpayer had determined the arm’s length price of their international transactions on the basis of internal bench marking analysis. The Tribunal upheld the transfer pricing method followed by the Taxpayer whereby the net cost plus margin earned from rendering software development and related services (“software services”) to associated enterprises (AEs) were compared with the operating profit margin earned from rendering software services to unrelated parties.
Taxpayer is a wholly owned subsidiary of Birlasoft Enterprises Ltd. India, which in turn is a wholly owned subsidiary of Birlasoft Inc., USA. The Taxpayer is engaged in the provision of software development and related services. During the assessment year (“AY”) 2006-07, the Taxpayer entered into international transactions with two of its associated enterprises (AEs) for providing software services. The Taxpayer applied transactional net margin method (“TNMM”) for determining the arm’s length price by comparing the net cost plus margin earned from rendering software services to AEs with the net cost plus margin earned from rendering software services to unrelated enterprises. As, the net cost plus margin computed by the Taxpayer with respect to the international transactions with AEs was -0.47% as against the net cost plus margin of -6.89% earned from unrelated enterprises, the Taxpayer considered the international transactions to be at arm’s length. It is pertinent to note that the transactions with associated enterprises and those with unrelated enterprises were identical.
While applying TNMM, the Taxpayer had determined the net cost plus margin with respect to the transactions with AEs and unrelated enterprises by computing its profitability in two separate segments as below:
• Actual revenues earned with respect to transactions with AEs and Non-AEs were considered for computation.
• Other income (interest, dividend, rental income, etc.) was apportioned between the AE segment and unrelated enterprise segment on the basis of ratio of revenue earned by each segment.
• Costs which were directly attributable to the two segments (salary, travel and conveyance) were considered on actual basis.
• Some of costs (project delivery overhead and corporate overhead) could not be directly allocated to the two segments. Therefore, ratio of revenue earned by the two segments was used as the allocation key to make allocations in this regard.
The Taxpayer also contended that the allocation of revenue and costs were based on scientific basis considering defined allocation keys. Further, the segmental results were duly verified and certified by a Chartered Accountant.
The Transfer Pricing Officer (“TPO”) rejected the internal bench-marking of the Taxpayer on the ground that the Taxpayer had not maintained segmental accounts for the related and un-related transactions, and this was not reflected in the audited financial statements.
The TPO computed the arm’s length price based on an external benchmarking exercise, whereby six comparable uncontrolled companies were identified earning an average mark-up of 19.47% on cost.
Being aggrieved by the AO’s order, the Taxpayer filed its objections before the Dispute Resolution Panel (“DRP”) which rejected the Taxpayer’s contention of using an internal benchmarking analysis for computing the arm’s length price.
Aggrieved by the DRP’s directions, the Taxpayer filed an appeal before the Tribunal.
The Taxpayer’s contentions were as follows:
• The Accounting Standard-17 (“AS-17”), issued by the Institute of Chartered Accountants of India, requires segmental reporting of financial information about the different types of projects and services that the business has, including different geographical areas of operation. Since the transactions entered into by the Taxpayer with its associated enterprises, and unrelated enterprises were identical, therefore, separate segmental reporting of financial/operating results of transactions was not required to be made in terms of AS-17 in the audited financial statements.
• The profitability of the associated enterprise segment and unrelated segment was computed based on scientific basis considering allocation keys (i.e., ratio of revenue earned from associated segment to the revenue earned from the unrelated segment). Further, the segmental results were verified and certified by a Chartered Accountant.
• The internal bench marking analysis was based on the Rule 1 0B(1 )(e) of the Income-tax Rules which prescribes the application of TNMM. Further, internal bench marking analysis using TNMM provides the most reliable analysis compared to an external bench marking analysis.
• As per the Transfer Pricing Regulations, the revenue authorities do not have mandate to have recourse to external com parables, in case an internal com parables exists, which could be applied for determining the arm’s length price of international transactions.
• The TPO had accepted Taxpayer’s case for the AY 2005-06 based on the internal bench marking undertaken to determine the arm’s length price.
Ruling of the Tribunal
While ruling in favor of the Taxpayer, the Tribunal, inter alia, held as below:
• The Taxpayer was not required to report segmental financial statements as prescribed in AS-1 7 since identical services were provided by the Taxpayer to both its AEs as well as its unrelated enterprises. Therefore, lack of segmental reporting in the audited financial statements cannot be a reason of rejecting Taxpayer’s method of computing the arm’s length price by way of internal comparison made between the transaction with associated enterprise and unrelated enterprise.
• The Taxpayer had computed the net cost plus margin on a scientific basis considering different allocation keys. The internal comparison made by the Taxpayer to determine arm’s length price gets support from OECD Guidelines which provides that the net margin of the taxpayer from the controlled transaction should ideally be established by reference to the net margin that the same taxpayer earns in comparable uncontrolled transactions, and only where this is not possible, the net margin that would have been earned in comparable transactions by an independent enterprise may serve as a guide.
Internal comparison of profit margin earned from international transactions with AEs and profit earned from transactions with unrelated parties is justified under TNMM even where the segmental profitability is computed by allocation provided the allocation keys are rational and scientific.