Loss due to Recession in Software Industry after 9/11 incident cannot be ignored in computing ALP

IN THE ITAT HYDERABAD BENCH ‘B’

Infobahn Technologies Ltd.

versus

Deputy Commissioner of Income-tax

IT Appeal No. 962 (Hyd.) of 2003

[Assessment year 2002-03]

August 6, 2012

ORDER

Saktijit Dey, Judicial Member 

This appeal filed by the assessee is directed against order dated 8-9-2006 of CIT (A)-III, Hyderabad passed in ITA No.15/DC2(1)/CIT(A)-III/05-06 and it pertains to the assessment year 2002-03.

2. Though the assessee has raised 9 grounds, learned AR for the assessee at the outset submitted he wants to argue on ground Nos. 6(a) and 6(b) only. Considering the submissions of the ld. AR the other grounds raised are dismissed as not pressed. For the sake of convenience, grounds Nos. 6(a) and 6(b) are quoted below:-

“6(a) The ld. CIT (A) erred in allocating 80% of unbilled hours to the Associated Enterprise and consequently erred in arriving at the ALP of Rs.12,57,28,362 by ignoring the fact that the appellant suffered losses in the aftermath of bomb attack on World Trade Centre on 9/11 in US.

6(b) The ld. CIT (A) erred in overlooking the basic facts that the appellant was obliged to take 25 persons on a monthly basis as per the contract between the appellant and its AE and due to 9/11 incident, there were personnel “sitting on the bench”, who could not be deputed to any client/customer of the appellant. Consequently, the ld. CIT (A) failed to appreciate the loss incurred, and erred in attributing such business loss as unbilled hours of the AE”

3. Brief facts of the issue are, the assessee is in the business of software development by resourcing qualified personnel for the purpose. The assessee during the relevant financial year had international transactions with its Associated Enterprise (AE) M/s Cypress Associates Inc. Of USA which is its 100% subsidiary. On a reference made by the AO u/s 92CA(1) of the Act the TPO issued notice u/s 92CA(2) to the assessee for fixation of Arm’s length Price (ALP) in respect of the international transaction entered into by the assessee with its AE in USA. In course of the proceeding the TPO found that the assessee had paid an amount of Rs.13,39,79,178 to its AE M/s Cypress Associates Inc. USA @ Rs.61.39 USD for a total of 45,662 man hors whereas it has received charges for the technical services provided to its clients for 41,921 man hours. Before the TPO the assessee explained that it has entered into an agreement with its AE for hiring technical personnel to be engaged in its overseas project. As per the terms of the agreement the assessee will hire minimum of 25 employees per month and will pay 9700 USD per month per employee. When the TPO asked the assessee about the huge gap between man hour utilisation, the assessee explained that the total man hours utilised after deducting holidays and others, it comes to 158 hours per month. The assessee submitted that the average rate charged as per invoice raised on AE by the assessee is Rs.66.40 per hour whereas it has paid @ 61.39 USD per hour to its AE. The assessee also explained the difference between man hours by submitting that in the month of November, even though it employed only 10 it had to pay the amount for 25 people to the AE as per the agreement. Due to recession in the aftermath of9/11 terrorist attack in USA man power could not be utilised properly and the assessee incurred losses, hence closed down its operations. The TPO found that while the AE has supplied its man power to independent parties on actual man hour utilisation basis, it has provided manpower utilisation to the assessee on monthly payment basis. The TPO found the terms and conditions mentioned in the agreement between the assessee with its AE has put the assessee in a disadvantageous position conceding undue benefits to the AE. The TPO also found that while raising bills on third parties in respect of onsite operations, the assessee has quoted rates as per the technical abilities and the nature of such services rendered by such employees ranging between 50 USD to 90 USD. Whereas the assessee paid 61.39 USD per man hour to the AE without considering the technical expertise and quality of service provided. This, according to the TPO was a benefit given to the AE which ultimately reflected on the poor financial result of the assessee compared to other similar industries. The TPO found the difference between the man hours paid to AE and man hours charged from clients by the assessee to be 3741 man hours. After giving benefit to the assessee of 240 man hours for demo purpose the TPO came to the conclusion that the assessee has paid the AE for 3500 man hours in excess. He accordingly calculated the ALP. The payment made to the AE by the assessee was found to be not within the +/- 5% range and therefore was not accepted. The calculation of ALP by the TPO is reproduced below for the sake of convenience.

4. The AO completed he assessment by adopting the ALP determined by the TPO and made an addition of Rs. 1,03,13,520/-. The assessee challenged the determination of ALP and addition made as a result of such determination by filing an appeal before the CIT (A). In course of hearing of appeal before the CIT (A), the assessee submitted that excluding American holidays in the year 2001 the average working hour in a month will come to 158 hours, which work out to total of 45662 man hours billed by the AE. Further explaining the difference of 3741 man hours between the man hours billed by the AE on assessee and man hours billed by the assessee on its clients the assessee submitted that in the aftermath of 9/11 incident in USA, there was steep loss incurred by the assessee which is evident from the invoices for the month of November, 2001 when payment was made for 25 personnel but the assessee could deploy only 10 personnel which resulted into a difference of 2370 man hours lost in 2001. And the balance difference of 1370 man hours was on account of various factors like privilege leave, sick leave, unbilled pilot projects and free demo purpose.

5. The assessee submitted that due to prevailing conditions in USA after 9/11 incident, there was sharp decline in the business of hiring technical personnel for which assessee was forced to close down its operation. The assessee was competing with bigger players in the field, hence it had to quote on low margin of profit and at the same time recruit software personnel by offering good packages. It was further contended by the assessee that TPO has not adopted proper number of man hours vis a vis the actual number of working days. If proper number of man hours were reworked the difference would be 1370 man ours which come to the value of Rs. 40,37,006/-. If this amount is reduced from the payments made to AE then the ALP would be Rs. 12,99,42,172/- and after taking the+/-5% range, the price paid by the assessee will be within 5% of such ALP. The assessee contended that the average rate of USD 61.39 per man hour at which payment was made by the assessee to its AE is closer to the minimum of the rates quoted by the assessee to others for the services, therefore the allegation of the TPO that excessive payment has been made to the AE was unfounded.

6. The CIT (A) after going through the terms of the MOU and the agreement between assessee with its AE found a stipulation that the payment has to be made for a minimum of 25 employees per month irrespective of the utilisation The CIT (A) found this clause to be unduly advantageous to the AE since the entire loss arising out of non availability and non utilisation of the employees has to be borne by the assessee which is contrary to the accepted contractual norms involving transaction between unrelated parties. The CIT (A) came to a conclusion that sharing of loss/expenditure arising out of unforeseen situations should be in the ratios of comparative situations and risks of the parties involved in the transactions which were not found to be the case in the agreement between assessee with its AE. As has been observed by the CIT (A) in his order after analysing the Transfer Pricing Study Report filed by the assessee the CIT (A) found that in the transactions between the assessee and its AE, most of the risk factors were associated with the AE. However the agreement with AE regarding payment for minimum 25 Nos. Of personnel put the assessee at a disadvantageous position contrary to the findings in the Transfer Pricing Study Report. The CIT (A) ultimately came to a conclusion that the agreement with AE was deliberately constructed in a manner so as to put all possible losses arising on account of unutilised manpower on the assessee. On the aforesaid conclusion the CIT (A) held that the agreement between the assessee and its AE was not at arm’s length and the payment made by the assessee to its AE for unavailable man power are excessive. The CIT (A) though agreed with the assessee’s contention that there was recession and adverse market conditions in software industry he was of the view that the same is applicable to all assessee’s engaged in this line of business and most of them have shown substantial profit compared to the assessee. The CIT (A) came to hold that out of the loss arising from payment made for extra 3500 man hours which were neither utilised or billed by the assessee 20% share in loss is allocable to the assessee considering the fact that as per the Transfer Pricing Study Report the AE had four times greater risk than the assessee. The CIT (A) treated the balance 80% man hour i.e. 2800 to have been excessively paid by the assessee to its AE. He therefore reduced the cost for 2800 man hours from the payment made by the assessee to its AE and determined the ALP at Rs.12,57,28,362 as below.

Since the payment made by the assessee to its AE was not within the +/- 5% of the ALP determined by the CIT (A) he directed the AO to adopt the ALP determined by him at Rs.12,57,28,362/- and added the differential amount of Rs.82.50,816 to the total income of the assessee. He further directed that as per the provisions of sec. 92C(4) on deduction u/s 10A to be allowed from the addition made to the income on account of determination of ALP.

7. The leaned AR submitted before us that the TPO proceeded on a wrong footing that payment to AE was on the basis of man hour whereas in realty payment was on the basis of number of personnel contracted per month. The learned AR submitted that due to recession in software industry after 9/11 incident in USA the assessee suffered huge loss as the technical personnel hired by it from its AE could not be deployed and were sitting on the bench. In the month of November 2001 it could deploy only 10 persons even though it has to pay to its AE for a minimum of 25 persons every month. Due to deployment of only 10 persons in November 2001 the number of unbilled hours lost was 2370 hours which leaves a shortfall of 1370 hours only which was also explained by the ld. AR to be due to personnel deployed for demo purpose., sick leave, privilege leave etc. The ld. AR further submitted even assuming there is excess payment for 1370 man hours the payment made by the assessee to its AE will be within +/- 5% range of ALP. The ld. AE demonstrated it with the following calculation.

The learned AR further submitted that when the assessee’s income is exempt and the AE’s profits are taxable there was no reason on the part of the assessee to make excess payment to its AE.

8. The learned DR strongly defending the order passed by the CIT (A) submitted that the assessee has deliberately made excess payment to its AE with an intention to reduce its profit. The learned DR submitted that the CIT (A) after considering all aspects has correctly determined the ALP.

9. We have heard rival submissions, perused the orders passed by the revenue authorities and also the documents submitted in the paper book by the assessee. After analysing the ALP determined by the TPO, CIT (A) and ALP computed by the assessee we find there is no dispute with regard to man hours paid to AE by the assessee and man hours charged by the assessee from its clients. The difference between the two being 3741. The TPO has determined the ALP by deducting excess payment for 3500 man hours after giving benefit of 241 man hours to the assessee being unbilled for demo purpose. The CIT (A) has allowed the assessee further benefit of 750 man hours and determined the ALP after considering 2800 man hours being excess payment made to AE.

10. The ld. AR has demonstrated before us that if at all it is to be assumed that the assessee has made excess payment to the AE then it should be confined to 1370 man hours since 2370 man hours could not be billed to clients as assessee could deploy only 10 persons in November 2001 whereas it had to pay to its AE for minimum 25 persons as per the terms of the agreement. As it appears, the CIT (A) even though accepts the fact that the difference in man hours paid to the AE and billed to the clients is due to recession and slump in software industry after the 9/11 incident, he nevertheless making his own interpretation of the agreement came to a conclusion that assessee can be allowed benefit at 20% out of the loss arising from payment made for extra 3500 man hours as the AE had four times risk in the transactions. We find the aforesaid conclusion of the CIT (A) is without a reasonable basis. When the assessee has paid to the AE for a minimum of 25 persons as per the terms of the agreement whereas it could bill its client for 10 persons the CIT (A) was not justified in coming to the conclusion that the assessee could be given benefit of 20% out of the loss arising on account of excess payment made for 3500 man hours. It is a fact that assessee’s business suffered due to recession as result of 9/11 incident and assessee ultimately had to close down its operations. The CIT (A) also does not dispute this fact. We also find force in ld. AR’s contention that assessee’s income being exempt there was no need on its part to transfer its income to its AE whose profit was taxable. The ld. AR has demonstrated before us the ALP at Rs.12,99,42,172/- after deducting cost of 1370 man hours @61.39USD and the payment made by it to the AE to be within +/-5% of the ALP range which we are inclined to accept. In the aforesaid factual situation, we set aside the order of CIT (A) and direct the AO to verify the invoices raised by the assessee on its clients and invoices raised by the AE on the assessee to find out the actual unbilled hours lost in November, 2001. If the assessee’s claim will be found to be correct, then no addition can be made under the Transfer Pricing Regulations. The AO shall afford reasonable opportunity of being heard to the assessee before completing the proceedings.

11. In the result, the appeal filed by the assessee is treated as allowed for statistical purposes.

NF