Only the expenses that have been incurred after the date of entering into agreement are liable for mark-up

Executive Summary:-The Income Tax Appellate Tribunal (the “Tribunal”) of Hyderabad, on 31 January 2011, pronounced its ruling in the case of M/s Convergys Information Management (India) (P) Ltd. Vs DCIT, Hyderabad, ITA No. 229/H/2009, on whether the expenses incurred prior to the date of entering into agreement are subject to mark-up. The Tribunal ruled in favour of the Taxpayer stating that only the expenses incurred after the date of entering into agreement are liable for mark-up.

Facts

The Taxpayer provides software development and product support service to its associated enterprise (“AE”), M/s Convergys Information Management Inc. USA. The relevant financial year 2003-04 is its first year of operation. The Taxpayer entered into an R&D agreement with its AE on January 01, 2004 which provided for a mark-up of 10% on the costs incurred as remuneration for the services. The Taxpayer raised invoices on the AE for product development charges for the expenses from the period March 15 to March 31 and added a 10% mark-up thereon.

The TPO however observed that the Taxpayer had recruited technically skilled and administrative staff prior to the date of agreement. Hence the TPO held that these expenses were meant for carrying out R&D work prior to commencement of commercial operation. In view of above, the TPO computed the expenditure incurred by the Taxpayer from July, 2003 to March 14, 2004, on which the 10% mark-up was computed as Rs. 38,90,247, and was adjusted in the international transaction vide its order u/s 92CA(3) of the Act.

Being aggrieved, the Taxpayer filed an appeal before the CIT (A). The CIT (A) observed that the expenses incurred post agreement i.e. January 01, 2004 to March 14, 2004 are the only expenses to be treated as incurred for product development service, on which the Taxpayer is eligible for 10% mark-up.

Accordingly, the CIT (A) confirmed Taxpayer’s position.

In appeal before the Tribunal, the Revenue submitted that there is no evidence regarding the price adopted by the Taxpayer, thus the ALP computed by the TPO should be considered. In response the Taxpayer submitted that the evidence before lower authorities provides details of expenses incurred from January 01, 2004 to March 14, 2004, i.e. the expenses after the date of the inter company agreement, and the only expenses liable for mark-up. The evidence provided by the Taxpayer was in the form of comments in notes to accounts by Statutory Auditor on the date of commencement, Chartered Accountants Certificate intimating date of commencement to STPI, intimation to Commissioner of Customs & Excise regarding the commencement of commercial operations and the agreement with AE executed on January 01, 2004. According to the taxpayer the above mentioned documents supported the position that the provision of services commenced from the date of service agreement. The Taxpayer further submitted that even if the Revenue’s contention is accepted the cost plus mark-up amount should fall within the 5% range under proviso to Section 92C(2), thus negating the need for an adjustment.

Ruling of the Tribunal

The salient aspect of the Tribunal’s order is as follows:-

• The Tribunal found merit in the contentions of the CIT (A) that the expenses incurred post agreement are liable for the mark-up at 10% since no customer would pay mark-up before entering into the agreement. The Tribunal bifurcated the expenses incurred up to March 15, 2004 as follows:

a) Expenses incurred up to December 31, 2003 – Rs.1 ,34,84,885

b) Expenses incurred January 01, 2004 to March 14, 2004 – Rs. 2,54,17,576

Accordingly, the Tribunal upheld the decision of the CIT(A) of considering 10% mark-up on the expenditure incurred from January 01, 2004 to March 14, 2004. Further, the Tribunal also noted that the Revenue had not brought any material on record to show that the assessee had incurred any expenditure before entering into service agreement on the impugned issue.

Conclusion:-The ruling establishes that the expenses incurred only after the date of entering into the agreement are liable for mark-up. However, the ruling also places emphasis on the need to have supporting documents to evidence the linkage between the expenditure incurred towards the provision of services and the date of service agreement. Hence, the data of service agreement is unlikely to be a conclusive factor in determination of the period for which expenses should be considered for the purpose of applying mark-up.