Ordinary profits’ referred to in Section 80IA is different from ‘ALP’

The Tribunal placed reliance on the Chennai Tribunal ruling in the case of Tweezerman (India) Private Limited v. Addl. CIT, [2010] 4 ITR (Trib.) 130 (Chennai) which ruled that provisions of Section 80-IA(10) of the Act do not give an arbitrary power to the AO to determine the profits of the taxpayer. It is incumbent on the AO to show how ordinary profits were computed based on similar comparable case.  The phrase ‘more than ordinary profits’ referred in Section 80-IA(10) of the Act is different from ‘ALP’.

The Tribunal held that TPO had confirmed that that taxpayer had received the revenue due to it and there was no adjustment made in the affairs of the AE so as to deprive the taxpayer of the revenues in the country. The AO had not shown the actual ordinary profits which the taxpayer could have generated and the particulars used for arriving at a figure when the taxpayer had filed the calculation showing the error in the difference between the profits and the ALP filed before the TPO. The Tribunal set aside the case to the AO with the direction to verify the comparables in the light of the decision in the case of Tweezerman (India) Private Limited.

INCOME TAX APPELLATE TRIBUNAL, HYDERABAD

ITA Nos. 914 & 915/HYD/2006 and 1797/HYD/2008

Assessment Years: 2003-04, 2004-05 & 2005-06

Weston Knowledge Systems & Solutions (India) Pvt. Ltd.,

Vs.

The Income Tax Officer

Date of Pronouncement : 26/04/2012

ORDER

PER ASHA VIJAYARAGHAVAN, J.M.:

This appeal filed by the assessee is directed against the order of CIT(A), Guntur, passed on 28/05/2010 for the assessment year 2007-08.

2. The assessee is a domestic company engaged in the business of providing software development services. For the ASSESSMENT YEAR 2003-04, the assessee filed its return of income on 27/11/03 declaring a total income of Rs. 4,80,889/- after claiming deduction of Rs. 41,21,672/- v/s 10A of the Act.

3. For the assessment year 2004-05, the assessee filed its return of income on 21/10/2004 declaring a total income of Rs. 55,11/-after claiming deduction of Rs. 34,06,060/- v/s. 10A of the Act.

4. The Assessing Officer completed the assessment v/s. 143(3) on 30/12/05 for both the assessment years under consideration restricting the 10A deduction to Rs. 25,67,227/-and Rs. 31,13,225/-for ASSESSMENT YEAR 2003-04 and 2004-05 respectively. Aggrieved by the order of the Assessing Officer, the assessee carried the matter in appeals before the CIT(A).

5. The CIT(A) agreed with the findings of the Assessing Officer for both the years under consideration and confirmed the same. Still aggrieved, the assessee is in appeal before us.

6. For the assessment year 2003-04 ground Nos. 2 to 4 and for the assessment year 2004-05 ground Nos. 3 & 4, the assessee at the time of hearing did not press, the said grounds. Only the alternate ground, which is as follows and common for both the years, was contested before us:

“Without prejudice to the appellant’s submission that communication charges are not to be reduced from the export turnover, the learned CIT(A) ought to have appreciated that these expenses, if reduced from the export turnover are also be reduced from the total turnover.”

7. The issue is no more res-integra and the same is covered by the decision in the case of ITO Vs. Sak Soft Ltd., reported in 313 ITR (AT) 353, wherein the Hon’ble ITAT,   Chennai (SB) held that in absence of definition of total turnover, the meaning of the said term for purposes of sections 8OHHC and 8OHHE and 8OHHF are to be applied. It was held that parity is to be maintained with export turnover. Expenses on freight, telecommunication charges or insurance attributable to delivery of articles or things or computer software, required to be excluded from export turnover, are also to be excluded from total turnover for computing exemption u/s. 10B/10A. In this context, it is pertinent to refer to the following observations made by the Hon’ble ITAT, Chennai Special Bench, in para 52 at page 397-398 of the said decision:

“The parties have compiled several orders of the Chennai and Bangalore Benches of the Tribunal in which it has been held that whatever is excluded from the export turnover should also be excluded from the total turnover for the purpose of section 10A or 10B of the Act. We are generally in agreement with the conclusion reached in these orders, which are not being dealt with individually.

For the above reasons, we hold that for the purpose of applying the formula under sub-section (4) of section 10B, the freight, telecom charges, or insurance attributable to the delivery of articles or things or computer software outside India or the expenses, if any, incurred in foreign exchange in providing the technical services outside India are to be excluded both from the export turnover and the total turnover, which we are the numerator and denominator respectively in the formula.”

Respectfully following the decision of the Chennai Special Bench in the case of Sak Soft Ltd. (supra), we allow this ground of appeal of the assessee for both the years under consideration on this issue.

8. For the assessment year 2004-05 one more issue raised by the assessee is pertaining to reimbursement of onsite expenses as part of total turnover. The Assessing Officer added the reimbursement to the total turnover and excluded the same from export turnover in view of Explanation 2(iv) of the section 10A of the Act. On appeal, the CIT(A) upheld the order of the Assessing Officer. Aggrieved, the assessee is in appeal before us.

9. After hearing both the parties and perusing the record, we find that this issue is covered by the decision of the coordinate bench in the case of Mis Virtusa (India) Ltd. in ITA No. 1502/Hyd/2010 & C.O. No. 06/Hyd/2011 for AY 2004-05 order dated 26/12/2012, wherein the coordinate bench held as under:-

“9. Now, we deal with the Cross Objection filed by the assessee. The facts relating to ground No. 1 are that the assessee has objected to the decision of the assessing officer in treating the amounts of Rs.3,32,64,411/-and Rs. 2,99,55,472/-, shown as towards reimbursement of miscellaneous expenses and travel expenses respectively, as part of total turnover in their case. In the written submissions filed by the learned authorized representative of the assessee, it was submitted that miscellaneous expenses were incurred by the assessee in providing services to the clients of Virtusa Corporation, USA. These expenses include customer specific software license, on-site travel, dedicated tools and communication infrastructure. The same were reimbursed as per Exhibit-B of the services agreement between the assessee company and Virtusa Corporation. It was further submitted that the travel expenses incurred by the employees of the assessee company for traveling outside India were reimbursed by Virtusa Corporation, USA, in accordance with said service agreement. Stating that such amounts were mere reimbursement of actual expenses  incurred by the company and no turnover is involved therein, the assessee contended that the same should not be treated as part of total turnover. In this regard, reference was made to the decision in the case of CIT vs. Industrial Engineering Projects Pvt. Limited 202 ITR 1014 (Del.). It was further submitted that the assessee has incurred such expenses on travel of its employees, who went abroad for on-site work at the request of their client Virtusa Corporation, USA. Lastly, stating that such expenses were incurred on behalf of Virtusa Corporation and the same were reimbursed by the latter, the assessee contended that the same should not be added to the total turnover. The DR relied on the orders of the lower authorities.

10. We have considered the rival submissions of the parties and perused the material available on record. We find that a similar issue came up for consideration before this Tribunal in the case of DCIT vs. IBS Software Services Pvt. Ltd. (129 ITD 21) (Cochin) wherein it was held that reimbursement of miscellaneous expenses and travel expenses are to be reduced both from export turnover as well as from total turnover while computing deduction uis. 10A of the Act. Same view has been taken in the case of Patni Telecom (P) Ltd., vs. Income-tax Officer (2009) 120 ITD 105 (Hyd). Accordingly, we allow the ground taken by the assessee in its Cross Objection.”

Respectfully, following the said decision of the coordinate bench, we direct the assessing officer to exclude the expenditure in question, from both the export turnover as well as total turnover for the purpose of computation of benefit under S.10A of the Act. Thus, this ground of appeal of the assessee is allowed.

10. The next issue, which is common in assessment years 2003-04 & 2005-06, is with respect to the adjustment of profits v/s. 10A(7) r.w.s. 801A(10) of the Act.

11. Briefly, the facts relating to this ground are that the assessee company is a subsidiary of Weston Solutions Inc., USA, which holds 99.99% of the equity of the assessee company and all the transactions for provision of services during the year were made with such holding company which has been referred to as associate company for which a sum of Rs. 2,00,19,973/-was charged during the year under consideration. The Assessing Officer obtained the transfer pricing analysis report from the assessee as required under Rule-10D of the IT Rules. As per the study report, the arithmetical mean level of margins earned by other comparable cases was 14%, whereas in the assessee’s case it was around 23.84%, which was more by 70% of the arithmetical mean which is substantially higher than the ordinary profit expected to arrive in this line. In view of the fact that all the sales were made to the assessee company holding 99.99% equity of the assessee company and substantially higher than ordinary profits were earned therefrom, the assessee was asked to show cause as to why the deduction allowable v/s. 10A should not be reworked applying the provisions of section 10A(7) r.w.s. 80IA(10) of the Act. In reply, the assessee filed its objections vide letter dt 16i12i2005, wherein the assessee’s contentions were as under: –

“i) Relying upon the TP study not be made for determination of ordinary profits – TP not exact science.

ii) Ordinary profits neither defined in sec. 10A nor in sec. 801A(10).

iii) Ordinary profits to be decided on the basis of the facts of the case.

iv) TP study is for determination of arm’s length standard and not for determination of arm’s length price – reference made to page 1 of our TP report.

v) OP/TC of Weston @ 24% is only unadjusted arithemetical mean and not ‘ordinary profits’. In includes loss making company also.

vi) Industry average rate is only an indication and not a benchmark.

vii) Profit margin depends on cost efficiency, off-shore¬onshore mix, quality of human resources.

viii) Assessee resorted to working capital adjustment – holding days 166 days, mark up after adjustment of comparables – 15-28%, Weston India – 23.48%.

ix) Assessee relied upon inter-quartile range – lower quartile – 6%; Upper Quartile – 36% – refer page no. 58 of TP report and table 9 Quartile range as submitted by the assess ee.

x)Data of comparable companies used in the TP report pertains to FYs 2000-01 and 2001-02 and arithmetical mean of 14% of the comparables pertains to average.

xi) Assessee relied on Circular No. 14 of 2001 – where such onus is discharged by the assessee and the date used for determining the arm’s length price is reliable and correct, there can be no intervention by the Assessing Officer.

xii) Assessee submits that it has entered into a basic ordering agreement – as per exhibit B of the agreement.

@ $30 per hour – software development

@$20 per hour – publications/administration/finance services;

@8 per hour – data development

xiii) Also, as per para 3.24 and 3.25 of the TP report – page 21 of the report – hourly industry rates are $18-$25 per hour – presentation of kiran karnik.

xiv) In response to question on risks, assessee contended that downward adjustment cannot be made since risk cannot be quantified in value/profit terms.

xv) Assessing Officer should have considered only profit making companies eliminating 5 companies – 38 companies only are to be compared out of 43 companies. Mean of the 38 companies is 19.53%.

xvi) Even if we consider risk adjustment of 2.16% and 5% as given by the Assessing Officer mean is 22.36%.”

12. After considering the submissions of the assessee, the Assessing Officer invoked the provisions of section 1OA(7) r.w.s. 80IA in assessee’s case. Aggrieved, the assessee carried the matter in appeal before the CIT(A).

13. Before the CIT(A), the assessee raised another ground that even if the provisions of section 80IA(10) are invoked the price should be determined only as per the ‘ordinary profits’ which is referred to in section 80IA(1). The assessee then refers to the page 120 of Transfer Pricing Analysis Report wherein while taking average of 43 companies of profits, the loss making companies which are listed out in the report are five, which according to the assessee, should be ignored while arriving at the ordinary profits. The CIT(A) held that profits include losses as well and in the process of averaging, the loss making companies had rightly been taken into consideration, therefore, the percentage of profit adopted by the Assessing Officer is on correct lines as per law. Aggrieved, the assessee is in appeal before us.

14. The learned counsel for the assessee relied upon the decision of Tweezerman (India) P. Ltd. Vs. Addl. CIT, [2010] 4 ITR (Trib.) 130 (Chennai) and Digital Equipment India Ltd. Vs. DCIT, 103 TTJ (Ban.) 329 and submitted as follows:

i) The CIT(A) erred in upholding the application of the provisions of section 10A(7) read with section 80IA (10) of the Act and in sustaining the reworking of the deduction allowable v/s. 10A of the Act and in sustaining the reworking of the deduction allowable v/s. 10A of the Act. He ought to have appreciated the fact that the assessee’s mark up is within the inter-quartile range   which fairly represents the ordinary profits generally earned by the companies.

ii) The CIT(A) ought to have appreciated that the profits earned by the comparable companies for the FY 2002-03 are to be considered, instead of considering the average mark-up for the previous two years 2000-01 and 2001- 02 for the purpose of determining ‘ordinary profits’ v/s. 80IA(10). The CIT(A) had not appreciated that the industry profit rate cannot be ‘ordinary profits’ in as much as the profit margin of a particular company depends upon the cost efficiency, offshore-onshore mix and other advantages enjoyed by the company like locational advantages, quality of human resources.

ii) The CIT(A) wrongly sustained the downward adjustments made on account of risk inasmuch as the risks in the nature of market risk, product risk, technology risk etc. cannot be quantified in values/profit terms; The CIT(A) failed to appreciate that the reduction of mark-up made by the Assessing Officer from 14% to 11.84% (i.e. reduction of 2.16%) cannot be quantified.

iii) The CIT(A) failed to appreciate that only the profit making companies from the Transfer Pricing Report of the assessee are to be considered in order to determine the ordinary profits. He also failed to accept the working capital adjustment on the ground that the assessee has no credit risk. Though the assessee has no credit risk by way of bad debts, the working capital adjustment is desired as the assessee’s carrying cost of receivables are higher than that of the comparables. Therefore, this  adjustment is desired before comparing the financials of the assessee with others.

iv) The CIT(A) was wrong in sustaining a downward adjustment to the arithmetical mean of comparable companies considered by the assessee in disallowing the excess net margin as representing the income representing extraordinary profits.

15. For the A.Y. 2005-06, the learned counsel contended that the Assessing Officer ought to have considered the facts of the case and data of the comparable companies change every year and, therefore, the Assessing Officer should not have relied upon the order made in the proceedings for the earlier year as the assessee has not earned any extraordinary profits during the assessment year 2005-06. The CIT(A) held that he was in agreement with the view taken by his predecessor in ASSESSMENT YEAR 2003-04 and upheld the stand of the Assessing Officer.

16. After hearing the learned DR and perusing the record as well as the orders of the authorities below, we find that in the case of Tweezerman (India) P. Ltd., [2010] 4 ITR(Trib) 130 (Chennai), the Tribunal held as under:-

“i) that the Transfer Pricing Officer had confirmed that the local associated enterprise being the assessee had received the revenue due to it and there was no adjustment made in the affairs of the associated enterprises so as to deprive the assessee of the revenues in the country. The Assessing Officer had not shown the actual ordinary profits which the assessee could have generated and the particulars used for arriving at a figure when the assessee had filed the calculation showing the error in the difference between the profits and the arm’s length price filed before the Transfer Pricing Officer. The provisions of section 80IA(1O) do not given an arbitrary power to the Assessing Officer to fix the profits of the assessee. Under the circumstances, the reduction of the eligible profits of the assessee by the Assessing Officer by invoking section 80-IA(1O) read with section 1OB(7) of the Act was not sustainable and consequently was to be deleted in toto.

17. The phrase ‘more than ordinary profits’ referred in section 80IA(10) is different from ‘arm’s length price’ as referred v/s. 92C of the Act. We, therefore, set aside the issue to the file of the Assessing Officer with a direction to verify the comparables in the light of the decisions of the in the case of Tweezerman (India) P. Ltd. and Digital Equipment India Ltd. (supra). Accordingly, this ground of appeal raised in ASSESSMENT YEAR 2003-04 & 2005-06 is treated as allowed for statistical purposes.

18. In the result, all the three appeals under consideration are treated as allowed for statistical purposes.

Pronounced in the open court on 26/04/2012.