Matter remanded if additions are made by TPO without working capital adjustments

IN THE ITAT DELHI BENCH ‘F’

Cowi India (P.) Ltd.

versus

Assistant Commissioner of Income-tax, Gurgaon Circle-1

IT APPEAL NO. 5052 (DELHI) OF 2010

[ASSESSMENT YEAR 2006-07]

APRIL 19, 2012

ORDER

Rajpal Yadav, Judicial Member

The assessee is in appeal before us against the order of Learned Assistant Commissioner of Income-tax dated 17.09.2010 passed under section 143(3) read with section 144C of the Income-tax Act, 1961 for assessment year 2006-07. It has raised thirteen grounds of appeal which are not in consonance with Rule 8 of the ITAT’s Rules, they are descriptive and argumentative in nature. In brief, its grievance is that learned Assessing Officer has erred in making an addition of Rs. 104,37,360 to the total income of the assessee by recomputing the arm’s length price of the international transaction under section 92 of the Act. In other grounds, the assessee has taken arguments in support of its contention that such an addition could not be made on the basis of pleas raised in these grounds.

2. The brief facts of the case are that assessee has filed its return of income electronically on 22.11.2006 declaring taxable income of Rs. 33,92,504. The case of the assessee was selected for scrutiny assessment and a notice under section 143(2) of the Act was issued and served upon the assessee. Learned Assessing Officer has observed that assessee company was formerly known as M/s. Kampsax India Pvt. Ltd. started its operation in India in October 1994 as infrastructure consultancy company. In 1998, it diversified its operation to digital mapping. The assessee is a 100% Export Oriented Unit registered with Software Technology Park of India. It is engaged in the production of large mapping which involved digital mapping, photogrammetry , GIS , satellite remote sensing, orthophoto etc. On an analysis of the accounts, learned Assessing Officer formed an opinion that assessee had entered into international transaction with its associate enterprises and, therefore, a reference under section 92CA(1) of the Act is required to be made to the learned transfer pricing officer under section 92-CA(3) of the Income-tax Act, 1961, in respect of those international transaction. Accordingly, a reference was made to the learned TPO. It emerges out from the learned TPO’s order that assessee has carried out following international transaction with its AE during the financial year 2004-05:

3. Learned TPO had made a detailed lucid analysis of the transaction carried out by the assessee with it’s A.E. in the light of transfer pricing provisions contained in Chapter-X of the Income-tax Act, 1961 read with Rule 10 of the Income-tax Rules, 1962. We will be referring the detailed discussion made by the learned TPO in the later part of this order. It emerges out that assessee has selected seven comparable in its TP Study Report in order to justify the arm’s length price disclosed by the assessee. It pointed out that arithmetic mean of average margin of these seven comparables is of 9.19%. It was determined by using three years data. The assessee’s margin is 11.36%, therefore, it was contended that its international transaction relating to provisions of digital mapping and CAD/CAM Services to it’s A.E. are at arm’s length price. Learned TPO excluded one of the comparables, namely, VJIL from the list of comparables. He also rejected the claim of assessee for making working capital adjustment and thereafter recommended the following adjustments in the arm’s length price of international transaction:

“8. Computation of arm’s length price:

8.1 In view of the above discussions, I proceed to make the computation of the arm’s length price as under:

8.2 Since the price charged by the assessee varies by more than 5% from the Arm’s Length Price, an adjustment of Rs. 1,04,37,360 is to be made to the income of the assessee, being the difference between the arm’s length price and the price charged by the assessee from it’s A.Es for export services. The Assessing Officer shall enhance the income of the assessee by an amount of R.1,04,37,360 while computing its total income. The Assessing Officer may examine issue of initiation of penalty u/s. 271(1)(c) of the Act in accordance with Explanation 7 of the same. No exemption u/s. 10B shall be admissible on such adjustment in accordance with proviso of Sub-Section (4) of Section 92C”

4. On the strength of learned TPO’s order, Assessing Officer has framed a draft assessment order which was served upon the assessee. The assessee has filed detailed objection on the proposed adjustment before the learned Dispute Resolution Panel but learned Dispute Resolution Panel without considering any of the objections raised by the assessee rejected them and directed the Assessing Officer to frame the assessment order. The brief order of the learned DRP reads as under:

“ORDER UNDER SECTION 144C OF THE INCOME-TAX ACT

The objections to proposed draft assessment order was objected to and the objections were filed before the DRP on 31.12.2009. The case was fixed for hearing on 23.7.2010, Shri Ankit Arora, Richa Gupta and Priyanka appeared on behalf of the assessee and argued the case.

The main objections related to the arms length, adjustment by the TPO to assessee international transaction with A.E. resulting in enhancement of income of Rs. 1,04,37,360. It has been alleged that the TPO has wrongly rejected the assessees comparability analysis specially in regard to rejecting VJIL Consulting Ltd. as a valid comparable company. The denial of working capital adjustment claim by the assessee has also been objected to and it has also been stated that the adequate opportunity was not provided to the assessee to explain the details. The assessee has also objecte4d to the use of current year data. There is objections also to initiate the penalty proceedings u/s. 271(1)(c) and charging of interest u/s. 234B.

Having gone through the arguments of assessee’s representatives, the paper book and the draft assessment order we find that the objections of the assessee has been dealt with in details by the TPO who after giving proper arguments and citations has proposed the arms length adjustment. The TPO has again considered the comparables put up by the assessee and after giving cogent reasons have selected certain comparables for making the comparability analysis. The rejection of working capital adjustment is also on the basis of cogent arguments. We do not agree that proper opportunity has been given to the assessee to put forward his arguments in details.

Therefore, the DRP doe not find any fault with the draft order of the TPO/A.O. As regards initiation of penalty proceedings and charging of interest we find it to be premature at this stage. Therefore, we do not find any pressing reasons to interfere with the order of TPO/A.O.

5. With the assistance of learned representatives, we have gone through the record carefully. The first area of dispute which could arise between the parties while determining the arm’s length price of international transaction entered into by the assessee with its associate enterprises is in respect of most appropriate method required to be adopted as provided in section 92C of the Income-tax Act, 1961 read with Rule 10B of the Income-tax Rules. Section 92C provides five main methods, namely, (a) comparable uncontrolled price method; (b) resale price method; (c) cost plus method; (d) profit split method; (e) transactional net margin method; and (F) one residuary method i.e. such other method as may be prescribed by the Board. The assessee in order to determine the ALP has adopted transactional net marginal method i.e. TNMM. Learned TPO did not dispute for the selection of this method, therefore, as far as selection of method is concerned, there is no dispute between parties. Therefore, no detailed discussion is required on this issue.

6. The next aspect where there could be a possible dispute is how to determine profit level indicator. Learned TPO has made a detailed analysis in this regard and ultimately observed that operating profit/total cost is to be selected as PLI for the benchmarking of the international transaction relating to ITSS/BPO. The assessee has also selected this very profit level indicator, therefore, there is no dispute about this procedural aspect also.

7. The next area of dispute is whether multiple year data is to be used or current year data is to be used. Rule 10(4) prescribed the use of current year data, learned TPO again made a detailed analysis of this issue and held that only current year data would be used. The assessee has challenged this conclusion of the TPO in ground No.9 of the grounds of appeal, however, at the time of hearing, did not press this ground of appeal, therefore, again there is no dispute between the parties about the data required to be used is the current year.

8. The next aspect is the selection of comparables. The assessee in its TP study report has selected 7 comparables. Learned TPO did not dispute about the selection of the comparables except in respect of one i.e. VJIL Consulting Ltd. He took into consideration the current year data of all the comparables. Out of the seven comparables, learned TPO excluded VJIL Consulting Ltd. According to the learned TPO basically there are three reasons for treating this company as incomparable. He made a FAR analysis i.e. (function performed, asset employed and risk assumed) of this company vis-à-vis that of the assessee company. According to the learned TPO, from the functional profile of the assessee company vis-à-vis the profile of VJIL, it revealed that both are entirely different. M/s. VJIL Consulting is not in digital mapping, photogrammetry, GIS, setlight remote sensing, orthophoto etc. The company is into software development and export of software. According to the learned TPO, the company cannot be held to be functionally comparable to the assessee. He further observed that subsidiary of VJIL Consulting is M/s. Mercury Outsourcing Management Ltd. This company is in the field of provisions of BPO/ITES Services. The subsidiary has been suffering persistent losses since 2001 and the function of the subsidiary are not comparable to the functions performed by the assessee. He also observed that VJIL Consulting Ltd. has fallen into huge operating losses for financial year 2006-07. Learned TPO noticed that on a turnover of Rs. 13.10 crores. The company has incurred a net losses of Rs. 10.53 crores. The company has been effected badly due to difference between the management of the company. The matter is now subjudice before the Hon’ble Andhra Pradesh High Court. That concern has created huge provisions for doubtful debt and has written of some items in the balance sheet. As per financial report, important documents, records and register relating to statutory accounting matters are not traceable. The stock and inventory registers have been lost. Thus, according to the learned TPO, this loss and untraceability of important statutory and accounting register and documents throws doubt on the veracity of the accounts of the previous year also. Learned TPO after excluding VJIL has worked out the margin of six comparable companies which read as under:

9. The learned counsel for the assessee while impugning the order submitted that learned TPO ought to have not excluded VJIL Consulting Ltd. from list of comparables. He pointed out that assessee has placed on record the comparables analysis of all the seven companies. He took us through pages 244 to 246 of the paper book and pointed out that if the exact nature of service is considered then most of the companies selected as comparables are not exactly comparables to that of assessee. He emphasized that if VJIL Consulting Ltd. is to be excluded then ALPHAJEO Ltd. should also be excluded because this company is engaged in Undertaking Seismic Service for oil exploration and for seismic data exclusion. According to the learned counsel for the assessee, VJIL provides the entire gamut of services to software product based companies ranging from software design and coding to maintenance and support. These services covered right from feasibility study and analysis to architecture design performance model; design coding, project documentation, Alfa and Bita Testing etc. Thus, VJIL Consulting deserves to be considered as comparables. On the other hand, Learned DR relied upon the findings of the TPO and pointed out that learned TPO has not only excluded this company for the functional analysis alone rather he has observed that in the absence of important statutory accounting register, its result are doubtful. This company has shown huge losses and that is the reason assessee wants to include it in the comparables.

10. We have duly considered the rival contentions and gone through the record carefully. As far as exclusion of Alphageo Ltd. pleaded by the learned counsel for the assessee before us is concerned, we are of the view that no such stand was taken by the assessee before the learned TPO. It is a comparable selected by the assessee which was accepted by the learned TPO and no objection at the end of assessee are discernible. At this stage, without giving a chance to the learned TPO to make a detailed analysis about its exclusion, it cannot be excluded. As far as the exclusion of VJIL Consulting Ltd. is concerned, we find that learned TPO has assigned five reasons on page nos. 13 to 17 of the order. The first reason is that this concern mainly engaged in software development, its software export is Rs. 1494.22 lacs which is quite high in comparison to the business profile of the assessee as well as the functional profile of the assessee. Learned TPO, thereafter recorded a finding that on an analysis of annual report for financial year 2006-07, it revealed that there was dispute in the management important statutory and accounting register and documents are missing hence veracity of its result cannot be ascertained. It has shown huge losses in financial year 2006-07, though in our opinion, profit and loss is an incident of the business and solely on that basis a comparable would not lost its status of comparability, but the cumulative setting of all other factors highlighted by the learned TPO on an FAR analysis, we are of the view that learned TPO has rightly excluded this concern from the list of comparables. Therefore, we do not find any merit in this submission raised by the learned counsel for the assessee.

11. In the next fold of submissions, learned counsel for the assessee submitted that assessee made a claim for working capital adjustment before the learned TPO. Learned TPO made a detailed analysis exhibiting how such an adjustment is to be granted. According to the learned counsel for the assessee, learned TPO made reference to Rule 10B(3) demonstrating comparability adjustment. On the strength of this Rule, learned TPO opined that Indian transfer provisions prescribed only reasonable accurate adjustment. He also pointed out that thereafter learned TPO made reference to OECD Commentary and also the judicial precedents on comparability adjustment. Learned TPO, however, did not consider the case of assessee on the ground that assessee failed to supply requisite information for making the working capital adjustment in the cases of the comparables. The learned counsel for the assessee while impugning this finding of the learned TPO submitted that assessee has submitted all requisite information, he took us through the letter of the assessee dated 4.3.2009 available on page No. 395 of the paper book, where assessee had contended adjustment on account of working capital gain. The learned counsel for the assessee drew our attention towards page 399 of the paper book which is an annexure exhibiting adjustment. Learned TPO has not made any reference to this letter. On the other hand, Learned DR relied upon the order of the Learned TPO and pointed out that specific information were not given by the assessee.

12. We have duly considered the rival contentions and gone through the record carefully. The assessee has raised a plea regarding working capital adjustment. Learned TPO made elaborate discussion on this issue and principally agreed with the submissions of the assessee that a working capital adjustment has to be given. His discussion in paragraph Nos. 7.8, 7.9 and 7.14 reads as under:

“7.8 General principles emerging from the above discussion: Various principles regarding comparability adjustment as laid down in above referred to judgments may be summarized as under:

 (a)  Rule 10B (1)(e)(iii) and 10B(3)(ii) stipulate for comparability adjustment.

 (b)  The OECD existing guidelines and the OECD draft issue notes on comparability public invitation to comment on a series of draft issue [CTPA/CFA (2006)] may be relied upon to make comparability adjustment.

 (c)  The comparability adjustment can be made for working capital, risk and growth and R & D expense.

 (d)  Rule 10B(3)(ii) provides for only reasonable accurate adjustment.

 (e)  As per OECD draft issue notes quality of data being adjustment, purpose of the adjustment, reliability of the adjustment and documentation are essential pre-requirement before a comparability adjustment could be made.

 (f)  Hon’ble ITAT in cases of Sony India Pvt. Ltd. (supra) and M/s. Philips Software Centre Pvt. Ltd. (supra) has allowed ad hoc or flat comparability adjustment however, Hon’ble Kerala High Court has stayed operation of the order in case of M/s. Philips Software Centre Pvt. Ltd. on the plea of the department that Rule 10B(3) stipulate for only reasonable accurate adjustment.

7.9. Claim of Working Capital Adjustment:

Whether there was material deviation in working capital of the assessee and finally selected comparables?

The working capital adjustment could be considered when a tested party exhibits different working capital intensities relative to a set of comparables. In other words, working capital adjustment implies adjustment for differences in the credit terms and working capital policies. There are three critical elements in working capital policy of any entity:

 (a)  Time lag between the sale of products and payments received, which creates accounts receivable;

 (b)  Time lag between the purchase of inputs and payments becoming due, which creates accounts payable; and

 (c)  Time lag between production and sale, which create inventories.

7.14 The working capital adjustments can not be made routinely for the opportunity cost of money tied up in working capital. The complex algebra is not worth since the accurate data is not available. The underlying assumption is that all the companies are efficient profit maximizers, but poor management may be the simple reality. In view of the above discussion, I reject the claim of working capital adjustment to the comparable or to the tested party made by the assessee without any empirical value/adjustment for following reasons:

 (a)  The assessee had not exhibited different working capital intensities relating to tested party and set of comparables which require working capital adjustment either in transfer pricing report maintained under Rule 10D or during the course of proceeding before me.

 (b)  The claim of the assessee for the ad hoc adjustment in line with the judgment of Hon’ble ITAT in case of M/s. Philips Software Centre Pvt. Ltd. (supra) cannot be accepted for following reasons:

   –  Rule 10B(3)(iii) stipulate for only reasonable accurate adjustment accordingly, no ad hoc adjustment can be allowed.

   –  the assessee did not exhibit different working capital intensities of tested party and comparables which require working capital adjustment.

   –  computation of working capital adjustment based on difference in working capital intensities if any was not filed. -operation of judgment of Hon’ble ITAT in case of M/s. Philips Software Centre Pvt. Ltd. (supra) in respect of ad hoc adjustment has been stayed by Hon’ble Karnataka High Court as discussed in paragraph 7.8(e) of this order.

 (e)  It is evident from FAR analysis as noted in transfer pricing report that the assessee had not detected any difference in working capital intensities of tested party and comparales which require adjustment. During transfer pricing audit, I have not selected any new comparable but had chosen a few comparables out of list of finally selected comparable by the assessee.”

13. Alongwith letter dated March 4, 2009, the assessee has submitted an annexure which is placed on page 399 of the paper book also and the annexure is as under:

14. This annexure suggests that assessee has given the relevant details but these details have neither been looked into by the learned TPO nor by the Dispute Resolution Panel. According to the assessee, learned TPO has not asked any further details after this letter otherwise assessee could have submitted any other details if required. Taking into consideration this aspect of the matter, we deem it appropriate that the issue required to be readjudicated, therefore, we set aside the impugned order, remitted it to the Assessing Officer for a limited purpose i.e. learned Assessing Officer shall investigate the issue about granting working capital adjustment to the assessee and if he wishes he can take help from the learned TPO. Learned Assessing Officer shall decide the issue in accordance with law after providing due opportunity of hearing to the assessee. On all other issues, his order is upheld.

15. In the result, the appeal of the assessee is partly allowed.