Notional Income Winding-Up Costs Not Taxable in Transfer Pricing: ITAT Delhi

Motricity India Private Limited Vs DCIT (ITAT Delhi)

The Income Tax Appellate Tribunal (ITAT), Delhi, delivered a significant ruling on January 10, 2025, in the case of Motricity India Pvt. Ltd. v. DCIT (ITA No. 1092/DEL/2023), addressing critical aspects of transfer pricing, winding-up costs, and the taxation of deemed income under the Income Tax Act, 1961.

The case, involving Motricity India Pvt. Ltd., a wholly-owned subsidiary of Motricity Pte. Ltd., Singapore, sets a significant precedent for companies terminating service agreement with their AE and / or ceasing operations under adverse business conditions. Motricity India was incorporated in December 2010 as a captive service provider to its Associated Enterprise (AE), Motricity Inc., USA, providing software services under a cost-plus 20% markup model governed by a service agreement for 2011. The agreement was not renewed during the year due to challenging business circumstances, and the parent company decided to wind up the Indian entity’s operations. For the assessment year 2012-13, Motricity India declared income only for the operational period till the date it provided the services to its AE and excluded all the expenses incurred post-date of termination of its service agreement with its AE—including exceptional cost such as retrenchment costs and asset impairments—from its transfer pricing analysis. However, the Transfer Pricing Officer (TPO) contended that these costs should also attract a 20% markup and income be also added for such period thus addition of deemed/notional income for the winding-up period in the company’s taxable income.

The ITAT examined the issues meticulously. On winding-up costs, it ruled that these did not qualify as operating expenses related to international transactions since they were entirely attributable to the AE’s decision to cease operations- taking clue from Rule 10TA of IT Rules. As such, they could not attract a markup. Regarding deemed income, the Tribunal emphasized that no services were admittedly rendered post-termination of service agreement, making the inclusion of notional income in the taxable base impermissible, consistent with the Supreme Court’s decision in CIT v. Shoorji Vallabhdas & Co., CIT, [1962] 46 ITR 144 (SC) and Excel Industries Ltd., [2013]/358/ITR/295 (SC) // (TS/506/SC/2013) and Ravi Kumar Sinha v. CIT, (TS/590/High Court/2024/Delhi)- ITA 281/2008. Order dated 14 Aug 2024, which held that only real income is taxable.

In this case, the terminated service agreement invalidated the TPO’s adjustments, which were based on hypothetical assumptions. It also noted that Motricity India voluntarily disallowed winding-up expenses in its tax return and the financial statement were NOT drawn on usual ‘Going Concern basis’ with audited financial statements explicitly reflecting the cessation of operations. The Tribunal concluded that non-operational expenses unrelated to the AE could not be included in the transfer pricing analysis.

This decision strengthens jurisprudence in transfer pricing and offers practical guidance for companies facing similar challenges.

FULL TEXT OF THE JUDGMENT/ORDER OF DELHI HIGH COURT

1. This appeal has been filed by the assessee against the order of ld. Commissioner of Income-tax (Appeals), Delhi-44 (hereinafter referred to as ‘ld. CIT (A)) for the assessment year 2012-13.

2. Brief facts of the case are, assessee filed its return of income declaring loss of Rs.4,83,50,864/- on 29.11.2012. The return was processed under section 143(1) of the Income-tax Act, 1961 (for short ‘the Act’). The case was selected for scrutiny through CASS and notices u/s 143(2) and 142(1) were issued and served on the assessee. In response, ld. AR of the assessee attended time to time and filed relevant information as called for. The Assessing Officer referred the matter to TPO under section 92CA(1) of the Act in respect of the international transactions entered by the assessee during the current assessment year.

3. The relevant facts of the case are, the assessee was incorporated on 3RD December, 2010 as a wholly owned subsidiary of Motricity Pte. Ltd., Singapore being part of Motricity Group USA. It was set up as a captive service provider to the group company i.e. Motricity Inc., USA. Motricity India provides software development lifecycle, future product developments, manage served and business analysis services to its Associated Enterprise (AE). A separate Motricity professional services team has also been set up for providing support to customers across Asia and the US. Motricity India have also installed data centre in New Delhi, significant enough to handle expected growth in Indian market. It would be providing full mCore Solution.

4. The assessee entered into service agreement with its AE (USA) with agreed revenue model. Based upon cost plus 20% mark up was agreed upon. The service agreement was entered effectively from 1^st January 2011 to 31^st December 2011. The effective period covered during the current assessment year is nine months i.e. from 01.04.2011 to 31.12.2011. As the assessee provides services to its AE, during the year it has reported international transaction in Form 3CEB as provision of services to the total value of Rs.23,86,70,931/- and reimbursement of expenses of fixed assets expenditure of Rs.21,19,26,943/-. The assessee prepared Transfer Pricing (TP) study and considered only the income earned during the period of nine months and submitted TP study report for software development expenses provided to its AE and Arms Length Price (ALP) is determined by applying Transactional Net Margin Method (TNMM). Operating profit of total cost ratio is determined as PLI in the TNMM analysis. The PLI of the company is arrived at minus 17.19% on cost whereas the average PLI of the comparables is arrived at 19.73% as per the analysis of the TP document. The price charged in its international transaction is more than the said arithmetic mean price, the price charged in the international transaction is treated at arm’s length. The assessee has submitted the following chart :-

5. After considering the TP report of the assessee, the TPO has accepted the TP study submitted by the assessee for the period of nine months, however he rejected the contention of the assessee that the assessee has not carried out any international transaction or provided any services to its AE during January 2012 to March 2012. After considering various comparables, the TPO arrived and finalized the following comparables and determined average OP/TC% of comparables at 20.92%:-

6. Based on the above chart, the TPO has computed the adjustment of arm’s length price as under :-

7. Accordingly, he determined the short fall in ALP at Rs.10,98,54,500/-.

8. A show-cause notice was issued to the assessee and the assessee raised several objections and also objected to the determination of ALP for fourth quarter and on its submission, assessee has submitted as under :-

“5. In response to the above-mentioned show cause notice, the assessee submitted its reply vide letter dated 20.01,2016 in which raised objections inter alia to the rejection of the assessee ’s comparables. The submissions of the assessee have been examined and duly considered as under:

In the financial statements prepared for the year ended March 31^st2012 & March 31^st2013 it was stated that “the management of the Holding Company has decided to close dawn the operations of the Company. Accordingly, these financial statements are not prepared on going concern basis and all assets bind liabilities are stated at estimated realizable value.”

For profitability analysis, the assessee company has divided its analysis in two periods:

• Pre termination of service arrangement i.e. April, 2011 to December, 2011. During this period, total operating cost incurred by the Motricity India for providing services to it AE was equal to Rs,199,889,205/-. On the same Motricity India charged a margin of 20% and earned a service revenue equal to Rs.238,670,931/-.
• Post termination of service arrangement i.e. January, 2012 to March 2012

In this period Motricity India has not provided any services to its AE, rather it focused on winding up its business. In this process and in three months, Motricity India a cost of Rs.190,608,393/-.

The expenses incurred by the company are farther bifurcated into:

In support of our claim of non deductible-expenditure incurred after 1^st January 2012, computation of income is placed again for your records.

Employee Cost: The expenditure beyond 1^stJanuary 2012 under this comprises majority of retrenchment Salary paid to employees. It is to be noted that during this period of three months, Motricity India significantly reduced its total workforce from One hundred and Twenty Nine employees in December 2011 to Just Thirty Three employees in January 2012 and further to Twenty Two employees in March 2012.

Details of number of employees on month-to month basis are enclosed herewith. All these expenses was incurred for services not provided to AE but are for needed for closure of business.

Admin & Other Operating Expenses: The expenses incurred under this head in the non agreement period comprises of balance’s w/off, legal fees for closure, rental expenses, accounting fees all needed for maintenance of the company and closure thereafter. Because of termination of contract, Motriciiy India also vacated the office premises before the minimum committed period. So the security amounting to Rs. 2,551,020/- lying with the landlord also got forfeited.

Depreciation is a non cash expense and is based on the life of the asset. The assets were not used for the business but as per the terms of Indian Accounting standard, depreciation had to be charged.

This is to again highlight to your good-self that the assessee has not claimed all these expenses as deductible u/s 37 of the Income Tax Act, 1961.

Your good-self in-your queries raised have considered OP/OC based on the numbers submitted in -the audited financial statements. However, we wish to inform your good-self that since ail expenses after 1^st Jan 2011 (during non-agreement period] are revenue expenses and are therefore required to be charged to profit & Loss Account The assessee company in its transfer pricing documentation prepared has shown the break­up of opera ting expenses & non operation expenses. The expenses incurred after 1^st Jan 2011 are all non operation expenses since these are incurred for services not provided to AE.

Considering the facts, that the assessee company has shown a mark-up of 20% during the operating period and has a OP/OC margin of 19.40%, the OP/OCs computed by your good-self is 20.92%.

Since the variation between the margin earned by the broadly comparable companies, so determined and the margin actually earned by Motricity India does not exceeds%, according to proviso to Sec 92C it is reasonable to conclude that Motricity India’s International transaction is at arm’s length price.”

9. After considering the above submissions, TPO has rejected the same and sustained the ALP adjustment made by him at Rs.10,98,54,500/- under section 92CA of the Act and accordingly, assessment order was passed.

10. Aggrieved, assessee preferred an appeal before the ld. CIT (A), Delhi-44 and filed detailed submissions which were similar submissions also submitted before the TPO. After considering the submissions of the assessee, ld. CIT (A) rejected the submissions of the assessee by observing as under :-

“8.1 The appellant has shown international transactions viz. service fee of Rs.23,86,70,931/- and reimbursement of expenses of Rs.21,19,26,943/-. The appellant has charged mark up on service fee but has not charged any mark up on reimbursements on the ground that the same pertain to the period post the agreement with the AE .

8.2 The appellant company was incorporated on 03.12.2010 as a wholly owned subsidiary of Motricity Pvt. Ltd., Singapore to provide software development, future product developments, managed services and business analysis services to its AE. The company entered into an agreement with its AE for a revenue model of mark-up of 20% on cost w.e.f. 01.01.2011 for a period of one year. It is informed that the appellant company carried on its business for one year and thereafter due to non-suitable business opportunities and other unforeseen circumstances, the service arrangement was not renewed beyond the period of initial one year.

8.3 It is contended that for pre termination of service arrangement i.e. April 2011 to December 2011, total operating cost incurred by the Motricity India for providing services to it AE was Rs. 199,889,205/- on which it charged a margin of 20% and earned a service revenue equal to Rs.238,670,931/-. It is claimed that expenses of Rs.190,608,389/- incurred post 31.12.2011 were all related to closure of business of appellant company on which no markup was charged.

8.4 The moot issue here is whether in the facts of the case, the appellant in arm’s length conditions, should have charged markup on the costs incurred post termination of service agreement with the AE.

8.5 It is observed that the appellant is a typical captive service provider. It had been set up to provide captive services only to its AEs and not to any outside party. The service agreement was terminated by the AE at the end of first year itself. Undisputedly any cost incurred post termination of agreement was incurred only because of the decision of the holding company.

8.6 The final accounts for the FY 2011-12 have been filed by the appellant. The Notes to of accounts states that “The management of the Holding Company has decided to close down the operations of the Company.”

8.7 Thus, clearly the company was set up by the parent company for receiving certain services on cost plus 20 % basis. Under the relevant agreement, the appellant had the assurance of getting markup on all the costs. The decision to terminate the service agreement and windup the appellant company just after one year has been taken by the holding company and the appellant did not have any say in the said decision of closing down operations in India.

8.8 As the setting up of appellant company, its business, revenue and closing down, everything was in absolute control of the holding company, the appellant was entitled to markup as decided in the service on all costs irrespective of the nature of costs. The decision to terminate the agreement was that of holding company. The appellant company cannot be denied markup on such costs in an arm’s length condition. No independent party would have agreed to not charging any markup on such costs. Therefore, the argument that no markup needs to be charged on the winding up costs is without any merit.

8.9 In view of the above discussion, it is concluded that the TPO was justified in computing markup on the entire cost incurred by the appellant. The addition in respect of transfer pricing adjustment is confirmed. These grounds of appeal are dismissed.”

11. Aggrieved, assessee is in appeal before us raising following grounds of appeal:-

“That on the facts and circumstances of the case, and in law:-

1. The Income-tax Department, Hon’ble Commissioner Income Tax (Appeal)-44 (the Hon’ble CIT(A)have erred on facts and in law by affirming the additions in income of the Appellant by Rs. 109,854,500/- for the AY 2012-13.

2. The Hon’ble CIT(A)/The Learned Assistant Commissioner of Income Tax, Transfer Pricing Officer – i(i)(i), New Delhi (“the Ld. TPO”)/Ld. AO erred on the facts and in the circumstances of the case and in law in framing the order u/s 92CA of the Income Tax Act, 1961 (‘the Act’) on findings which are erroneous in law, contrary to the facts and based on mere conjectures and surmises;

3. The Hon’ble CIT(A)/Ld. TPO/Ld. AO failed to appreciate the submissions made/ contentions raised by the Appellant and further erred in making several allegations, observations, assertions and inferences in the order, which were both factually incorrect as well as legally untenable;

4. The Hon’ble CIT(A)/Ld. TPO/Ld. AO have erred in not properly appreciating the fact that the assessee company has decided to close down its operations and the service agreement with the AE was terminated w.e.f. 1 January 2012 and accordingly its financial statements are not prepared on going concern basis.

5. The Hon’ble CIT(A)/Ld. TPO/Ld. AO have erred in not properly considering the fact that assessee company has not provided any services to its AE, post the termination of service agreement with them, and the incurrence of expenses post the termination of service agreement was with an object to close down the business of assessee company after 01.01.2012.

6. The Hon’ble CIT(A)/Ld. TPO/Ld. AO have erred in not properly considering the facts and submission of assessee company that, if for the sake of argument, it is accepted that the expenses post termination of service agreement i.e. 31.12.2011 are operating in nature, the learned TPO/AO should make addition to the extent of mark-up on such expenses which would have been Rs.19,005,592 (Rs. 90,848,908*20.92%). The Ld. TPO/AO has made additions of INR 109,854,500 on gross basis i.e. without allowing the deduction of expenses incurred by the assessee company and has increased the taxable income accordingly.

7. The Hon’ble CIT(A)/ Ld. TPO/learned AO while passing the final assessment order has failed to give allowance of the expenses which have been considered as “operating expenses” by them for the purpose of computation of Arm’s length price. In respect of the same, the assessee company request your good-self to allow claim of expense which were treated as “operating expenses” in nature by the Hon’ble CIT(A)/ Ld. TPO/learned AO.

8. The Hon’ble CIT(A)/Ld. TPO/Ld. AO have erred in disregarding judicial pronouncements in India in undertaking the TP adjustment.

9. The AO has grossly erred in proposing to initiate penalty proceedings under section 271(1)(c) of the Act.”

12. At the time of hearing, ld. AR of the assessee submitted that assessee was providing software services to its AE in USA and it installed data centre in New Delhi. Assessee has entered into a service agreement with its AE for a period of one year commencing from 01.11.2011 o 31.12.2011. The abovesaid service agreement which expired on 31.12.2011 was not renewed by the AE in view of the unfavourable business scenario as assessed by the group and also it decided to close the business of the assessee immediately after the expiration of the term of this agreement i.e. 31.12.2011. As a result of such fall out, there was heavy retrenchment of the professional which was undertaken effective from 01.01.2012 and remaining three months period of the impugned assessment year witnessed extra losses/ expenditure. The work force earlier employed by the company witnessed substantial reduction on a gradual basis and as against 129 employees employed as on 31.12.2011, it reduced to 33 employees in January 2012 and by end of March 2012, it was 22 employees. Further he submitted that there was also significant impairment of assets due to closure, amounting to Rs.10,19,35,658/-recorded in the value of various plant & machinery deployed by the company as stated hereunder:

12.1 In this regard, he referred to Profit & Loss Account at page 145 of Appeal Set as well as Note no 9 to Financial Statement at pages 151/122. He submitted that in view of this, the account of the assessee was also not drawn on ‘GOING CONCERN’ basis as duly mentioned in the Auditor’s report vide para no 3 of the Auditor’s Report and referred to page139 of the appeal set.

12.2 As regards Transfer Pricing Study Report(TPSR) & determination of ‘ALP’, he submitted that since the international transaction of providing services to its AE were confined to the 9 months period in the impugned year (April to Dec 2011), hence in the TPSR, for the purpose of determination of ‘ALP’, the relevant cost incurred in the 9 months period ending 31^st Dec 2011 were considered and the same was analysed against the revenue earned for the said period. He referred to Annexure 6 of the TPSR which is placed at page 138 of appeal set and depicts the segregation of the cost incurred for the 9 month period between April to December 2011 and for 3 months period January to March 2012 as briefly reproduced below:

12.3 Accordingly, he submitted that in the TP analysis, based upon the average margin earned by the comparable selected, the profit earned by the assessee was determined to be at arm’s length. He submitted that since the service agreement was valid till 31^st December 2011, hence the assessee company divided its profitability in two periods i.e. Pre expiration of service arrangement (i.e. April 2011 -December 2011) and during this period, total operating cost incurred by the assessee for providing services to it AE was equal to Rs.19,98,89,205/-. On the same, the assessee charged a margin of 20% and earned a service revenue equal to Rs. 23,86,70,931/-.

12.4 Further, with regard to return of income and treatment of losses suffered, he submitted that the assessee filed its return of income wherein it itself disallowed the entire cost incurred after 31^st Dec 2011 since the business was closed and also disallowed the Impairment cost and referred to computation of income vide page 63 of the appeal set where loss on account of expenses incurred post closure of business amounting Rs.8,76,63,710/- and impairment cost of Rs.10,19,36,658/- was disallowed. He submitted that this is also evident from ITR filed vide Schedule BP – Item No. 15 – Amount of 18,96,00,368 (8,76,63,710 + 10,19,36,658) is disallowed.

12.5 Further he submitted that the ld. TPO did not accept the fact of discontinuation of the service agreement between the assessee and its AE w.e.f 1^st Jan 2012 and decided to consider the total operating cost is at Rs.28,82,28,110/- [ i.e. Total cost of 28,85,60,935 incurred across the 12 months period after reducing interest cost of 3,32,826] and referred to Profit & Loss Account vide page no. 145 of appeal set. In this regard, he submitted that TPO has expressed as under:

“The assessee had argued for considering the expense related to post termination of service arrangements i.e. January 2012 to March 2012 as non-operating and thereby OP/OC margin is at arm’s length. The reply by the assessee and the documents submitted by the assessee has been perused and analyzed. The assessee has failed to bring out on the record why did it incur expenses after termination of agreement arrangements from January 2012 to March 2012 i.e for the three months in which the expenses is more than expenses for remaining 9 month of agreement period. The assessee has not made any counter submission against the comparables selected by the TPO for AY 2012-13 for the benchmarking the international transaction of providing the software development services. In the light of the above discussion and submission on the record, the reply of the assessee with regard to expense bifurcation  between normal and abnormal expenses is not acceptable.  Therefore, the operating profit by operating cost ratio has  been derived by taking into account the entire financial year revenue and expenses. In absence of any objection by the assessee over the comparables given in the showcause notice dated 15.01.2016 by the TPO, it is held that the assessee has no submission to made on record.”(Emphasis supplied).

12.6 He further submitted that thus, without recording any cogent reason, TPO has endeavoured to consider deemed revenue based upon operating cost incurred for the entire year and in turn, considered revenue even for the period (Jan to March 2012) when the assessee has neither rendered any service nor there was any agreement with its AE for the said purpose. He submitted that in his approach, the TPO also made certain changes in selection of comparable, however the assessee chose not to record any resistance for the same. He submitted that the TPO then has proceeded to compute the ALP as below:

12.7 Further ld. AR of the assessee submitted that afterward the assessee moved appeal before the ld. CIT(A), who also declined to grant relief to the assessee for the reasons recorded in his order and referred to paras 8.5 to 8.9 of the ld. CIT (A)’s order.

12.8 He submitted that it is a matter of admitted fact that post 31.12.2011, no service has been rendered by the appellant company either to its AE nor to any other entity. This is neither disputed by the TPO nor by the Ld. CIT(A). Further he submitted that it is also a matter of fact that the company was formed as a 100% WOS of the Motricity Group in order to work as a back up operation arm for the group and towards that purpose, the group also invested a fund of close of 25 crores in Indian entity and the Indian entity was also entitled to earn a profit at the rate of 20% of its entire operating cost which would be considered a quite good profit margin by any standard. He submitted that the TP analysis undertaken by the assessee as well as TPO produced the result of ALP close to the margin earned by the assessee.

12.9 Further he submitted that the only point of contention has been that the TPO did not accept a hard business reality in terms of the business decision by the AE of the appellant not to renew the service agreement for the reasons entirely attributable to business propriety and commercial wisdom of the business and which does not warrant any interference from anyone, much less from the tax authority unless they are able to bring on record evidence of any ulterior motive.

12.10 He submitted that the TPO and ld. CIT (A) also failed to realise that the entire loss caused by the disruption of the business would also be entirely suffered by the group only as there is neither any sale of business nor transfer of business entity. Further, he submitted that the cost incurred after 31.12.2011 has been suo moto disallowed in the return of income since entire cost was post the date of discontinuation of business. He submitted that the accounts of the company have been prepared on the basis that the business has been discontinued and hence not on GOING CONCERN BASIS. He further submitted that there is a substantial impairment loss cost of Rs.10,19,36,658/- has also been recorded and same has neither been claimed in the return of income.

12.11 He further submitted that the initial agreement was entered into for only 1 year period beginning 1^st January 2011 and hence the period of 12 months was split into two assessment years i.e. AY 11-12 and AY 12-13 and no assessment took place during AY 2011-12. He submitted that during impugned year, since the agreement was not renewed due to adverse business scenario, the group took decision not only to NOT RENEW the service agreement with the Indian arm but also close the business operation for all the practical purposes. He submitted that this is also clear from the Notes to accounts for the impugned AY 12-13 as vide note no. 19, it is clearly stated that the accounts of the assessee company have been drawn NOT on ‘GOING concern’ basis.

12.12 With regard to grounds of appeal No.1, 2, 3, 4 & 5 that International Transaction cannot be deemed, he submitted that the TPO has erred in determination of incorrect arm’s length price of Rs.34,85,25,431/- by considering the revenue for the entire 12 months period from April 1st 2011 till 31^st March 2012 whereas there was no international transaction between the AE and the assessee company for the period from 1^st Jan 2012 till 31^st March 2012. He submitted that there is no provision in the Act or in the relevant rules to deem an international transaction in the manner in which the ;d. TPO has deemed the revenue for the 3 month’s period after cessation/expiry of the service agreement between the AE and assessee. He submitted that it is trite law that it is the sole discretion of the businessman as to how he would structure & run his business and does not warrant any dictate from anyone much less from the revenue authority. He further submitted that the assessee, received a revenue of Rs.23,86,70,931/- for services rendered over a nine month period (April 2011 to December 31, 2011) whereas the TPO considered the revenue of Rs.34,85,25,431/-. The service agreement was operational for a 12-month period (January 1 to December 31, 2011), following which it became non-operational as the AE did not extend it and further the group, in its wisdom, took decision to wind up the business. He submitted that declaration to such effect was also recorded in the financial statement as well as Auditor’s report. Further, he submitted that a valuation of fixed assets was also undertaken since the ‘GOING CONCERN’ basis was no more applicable and hence an impairment loss of Rs.10,19,36,658 was also recorded in the financial statements. He further submitted that all these facts were conveniently ignored both by the ld. TPO as well as ld. CIT(A). Thus, he submitted that the decision of TPO to enhance the income by Rs.10,98,54,500/- was entirely illegal and motivated by baseless assumptions and erroneous findings. In this regard, he brought to our notice Rule 10TA of IT Rules which is as under :-

(j) “operating expense” means the costs incurred in the previous year by the assessee in relation to the international transaction during the course of its normal operations including depreciation and amortisation expenses relating to the assets used by the assessee, but not including the following, namely: —“

He submitted that thus, it is crystal clear that operating expenses means only those expenses which are incurred in relation to the international transactions. In the present case, he submitted that since the international transaction of provision of service to the AE is undertaken till 31^st Dec 2011 only hence the operating cost incurred till such date only could be considered for the purpose of analysis and determination of ALP as required under the ITA.

12.13 He submitted that in the present case, the expenditures incurred after the expiration of the agreement i.e. January 2012 to March 2012, do not pertain to international transactions or normal business operations. Instead, these are winding-up costs incurred solely for the purpose of closing down operations. He submitted that the assessee also did not claim these expenses in its return of income.

12.14 Further with regard to notional Income cannot be deemed taxable, he submitted that the ld. TPO erroneously included expenses incurred during the non-operational period (January to March 2012) in determining the Arm’s Length Price (ALP), despite no services being rendered to the associated enterprise (AE) during this time. He submitted that the service agreement was operational only for one year, from January 1, 2011, to December 31, 2011, and all services were provided within this timeframe and consequently, expenses incurred in the subsequent period (January-March 2012) fell outside the operational scope of the agreement. He further submitted that the TPO considered basis the expenses incurred during the non-operational period (January to March 2012) is notional income, which is not taxable under Indian law unless explicitly provided. He submitted that this aligns with the ruling in Hon’ble Supreme Court in CIT v Shoorji Vallabhdas & Co [1962] 46 ITR 144 (SC) where the Hon’ble Supreme Court emphasized that only real income, not hypothetical or notional income, can be taxed. Since no services were rendered during this period, no real income accrued and referred to that ruling as under :-

“If income does not result at all, there cannot be a tax, even though in book-keeping, an entry is made about a “hypothetical income”, which does not materialise. Where income has, in fact, been received and is subsequently given up in such circumstances that it remains the income of the recipient, even though given up, the tax may be payable. Where, however, the income can be said not to have resulted at all, there is obviously neither accrual nor receipt of income, even though an entry to that effect might, in certain circumstances, have been made in the books of account.”

12.15 Further he submitted that in the case of Nishith Kumar Mukesh Kumar Mehta vs DCIT (2024)(TS/582/High Court/Madara/2024), the Hon’ble Madras High Court held that while discretionary payments linked to ESOP diminution were taxable due to specific statutory provisions, the court also clarified that notional income cannot be taxed unless explicitly covered by law. Similarly, in the present case, there is no statutory provision supporting the inclusion of expenses for a non-operational period in the ALP calculation.

12.16 He submitted that in the case of Ravi Kumar Sinha vs CIT (TS/590/High Court/2024/Delhi), the jurisdictional High Court (HC) reaffirmed the well-established legal position under the Income Tax Act, stating that tax cannot be levied on notional income. The HC relied on the Supreme Court’s judgment in Excel Industries Ltd. to support its stance, emphasizing that the Act does not contemplate the taxation of hypothetical or notional income.

12.17 He further relied on the judgment of Hon’ble Supreme Court in Excel Industries Ltd. 358/ITR/295 (SC) which is a landmark decision that addresses the issue of notional or hypothetical income in the context of taxability under the Income Tax Act. In this case, the Hon’ble Supreme Court held that the tax authorities cannot tax notional or hypothetical income. Further he submitted that specifically, the Court clarified that tax is levied on actual income that has accrued or is received, and not on income that is merely an accounting entry or a notional figure.

12.18 He submitted that the case involved a situation where a company had claimed a tax deduction for a particular item, but the income related to it had not actually been received or accrued in the year for which the deduction was claimed and the Hon’ble Supreme Court ruled that tax liability arises only when there is actual income, and a mere accounting entry or notional income, which does not materialize or is not received, cannot be taxed. He submitted that the judgment reinforced the principle that income must be real, rather than theoretical, for it to be subject to taxation, and that tax cannot be levied on unrealized or notional income. (i) Three tests were also laid down by various decisions of the Supreme Court to determine when income can be said to have accrued: (a) whether the income is real or hypothetical; (b) whether there is a corresponding liability of the other party to pay the amount to the assessee & (c) the probability or improbability of realisation of the income by the assessee has to be considered from a realistic and practical point of view.

12.19 As regards Ground No. 6 & 7, he submitted that without prejudice to above and in alternative, the TPO in his quest to deem notional income pertaining to 3 months period from Jan to March 2012, also skipped to brings such income to tax after duly allowing the expenses incurred. He submitted that in other words, even if the incremental (notional) income of Rs.10,98,54,500/- was to be added by TPO, the assessee deserves to have been allowed the expense/cost incurred during this 3 months period i.e. Rs.8,86,71,730/-. He submitted that this cost has not been allowed to the assessee thereby the addition made by TPO has caused sort of double addition to the assessee company.

13. On the other hand, ld. DR for the Revenue objected to the submissions of the ld. AR of the assessee and relied on the findings of the TPO and also he brought to our notice findings of the ld. CIT (A) at page 7 of the order. He submitted that the assessee has charged mark-up on service fees but has not charged any mark-up on reimbursement on the ground that the same pertained to the period not covered by the agreement with its AE. He supported the conclusion of the ld. CIT (A) that assessee has claimed expenses of Rs.19,06,08,389/- incurred after expiry period where all related to closure of the business of the assessee company where no mark-up was charged and also submitted that assessee should have charged mark-up on the cost incurred basis and termination of the service agreement with its AE considering the fact that the unit was established by the group and also decision to terminate the facility also lies only with its AE, therefore, assessee has no role either in set up or closure of the business. Accordingly, he supported the findings of the lower authorities.

14. Considered the rival submissions and the material placed on record. We observed that the assessee has established a data centre at Delhi and also created a facility to provide software services to its AE by entering into a service agreement for the initial period of 12 months commencing from 01.01.2011 to 31.12.2011. The assessee has functioned effectively during the current assessment year for nine months and the operation of the assessee was stopped due to non-renewable of service agreement with its AE effectively from 01.01.2012. It is a fact on record that assessee has declared income for the period of nine months and also booked the relevant operating expenditure for the same period. While determining the ALP for the services, the TPO observed that the assessee has booked more expenditure post service agreement i.e. 01.01.2012 to 31.03.2012 and has not booked any income. Accordingly, he rejected the TP study submitted by the assessee and he selected 18 comparables and computed the average comparable price of 20.92% and he proceeded to determine the ALP for whole assessment year.

15. After considering the factual matrix in this case, we observed that the Balance Sheet which was prepared and certified by the statutory auditor based on the observation that the holding company has decided to close down the operations of the assessee company and accordingly, the financial statements are not prepared on going concern basis and all the assets and liabilities are stated at estimated realizable value. Further it is also brought to our notice that even in notes forming part of the “financials”, the basis of preparation of accounts were clearly stated that financial statements are preferred not on the basis of going concern. Further the assessee has submitted computation of margin sheets which is placed at page 138 of the paper book wherein assessee has bifurcated the business transaction for the period of April to December 2011 and January 2012 to March 2012. Further it is brought to our notice that in computation of total income, the assessee has disallowed the expenses relating to post closure of business to the extent of Rs.8,76,63,710/- and also impairment loss debited in the Profit & Loss account to the extent of Rs.10,19,36,658/-. We observed from the ITR filed by the assessee that all above disallowances were made by the assessee. From the above submissions, we observed that due to non-renewal of the service agreement and the decision to close down the business taken by the holding company, the assessee has technically declared the actual income and claimed only the actual expenditure incurred for carrying out the international transaction. As far as the expenditures incurred by the assessee during the period of January 2012 to March 2012 which includes the normal business expenditure and also impairment of various assets which were technically claimed by the assessee and further assessee has laid off several employees to give effect to the shut down process.

16. From the actual facts brought on record, we observed that the assessee has actually provided software services only during the period April 2011 to December 2011 and subsequent to that period, it has carried out effectively operations to shut down the business. Therefore, as per the provisions of the Act, the TPO has to determine the ALP of the international transactions carried on by the assessee. In this case, assessee has effectively carried on the international transaction only during period of service agreement. The TPO has to determine only the ALP for such international transactions carried on by the assessee. The TPO selected various comparables for which various financial statements of comparable comparison were prepared on the basis of going concern whereas financial statements of the assessee are prepared not on the basis of going concern. This was disclosed in appropriate places in the audited Balance Sheet itself. The TP study has to be carried on comparable basis on equal terms. This itself makes all the comparables selected by the TPO are liable to be rejected.

17. The ld. CIT(A) came up with a new finding that the assessee has to charge mark-up on reimbursement of expenditure relating to closure of business also with the observation that the assessee is a typical captive service provider. It was set up to provide captive services only to its AE and not to any outside party. The service agreement was terminated by the AE itself at the end of first year. Any cost incurred post termination of agreement was incurred only because of the decision of the holding company to this effect. After considering the above observation and factual matrix on record, we observed that no doubt holding company has set up infrastructure in India to do business in order to receive services, no doubt for captive services still the ALP has to be on the basis of services provided by the Indian entity and as per the agreement it can charge mark-up only on the services provided by the assessee not for the negative services for which the holding company already by investing in India eroded the capital by such decision to create facility in India and on the top of it Revenue authorities cannot presume and impose further mark-up on the expenses which are incurred technically to shut down the business.

18. After careful consideration, we observed that TPO has determined the ALP on the basis of presumption. No tax can be levied on notional income which was determined on the basis of transactions which are not technically international transaction. All funds remitted to India will not fall under services or under international transaction having economic impact. On similar ground, the Hon’ble Supreme Court held in the case of Excel Industries Ltd. (supra) and Hon’ble jurisdictional High Court in the case of Ravi Kumar Sinha (supra) expressed similar view that the tax levied on actual income that has accrued or received and not on the notional or hypothetical income. Accordingly, we are inclined to delete the ALP adjustment made by the TPO in the present case and accordingly, grounds raised by the assessee are allowed.

In the result, the appeal filed by the assessee is allowed. Order pronounced in the open court on this 10^th day of January, 2025.