Period of license cannot be considered on the issue of capitalisation of software expenses: ITAT

Hewlett-Packard (India) Software Operation Pvt. Ltd Vs JCIT (ITAT Bangalore)

Conclusion: The ITAT in the case of Transfer Pricing observed that the exclusion and inclusion of comparable companies could be determined on basis of the Judgments of Yahoo Software Development (India) Pvt. Ltd. (2020) 115 taxmann.com 60 (Bang Trib) and Goldman Sachs Services Pvt. Ltd. (IT(TP)A No. 2355/Bang/2019. Also while dealing with the issue of capitalisation of software expenses it was held that “period of license” cannot be considered but the kind of software “system software or application software” shall be taken into consideration.

Facts: The assessee is a private limited company and engaged in the business of providing software development support services in the field of e-commerce, e-solutions, e-services, internet security and management etc. to its AEs. During the year under consideration the assessee filed return of income on 29.11.2015 declaring total income of Rs.197,11,40,320/- under normal provisions of the Act and book profits u/s.115JB of the Act at Rs.213,86,35,291. The case was selected for limited scrutiny under CASS and notice under Section 143(2) of the Act was duly served on the assessee. Since the assessee had international transactions the case was referred to the Transfer Pricing Officer (TPO) to determine the arm’s length price (ALP) of the international transactions the assessee has entered into with its Associate Enterprises (AE). The TPO made an adjustment of Rs.88,57,09,275/-. The Assessing Officer passed the draft assessment order incorporating the transfer pricing adjustment. The Assessing Officer further made an adjustment under Section 28(iv) of the Act for an amount of Rs.42,06,52,318/- towards the assets received by the assessee free of cost from its AEs. The Assessing Officer further made disallowance towards software expenses though allowed depreciation on the software expenses including those treated as capital asset in earlier years thereby arriving at the assessed income of Rs.256, 82,16,330. Aggrieved assessee raised its objections before the DRP. The DRP partially accepted the plea of the assessing on selection of comparable companies for determination of operating profit margin and directed the assessing officer to verify the nature of expenditure claimed with respect to software packages. Subsequently giving effect to the directions of the DRP and considering the various details furnished by the assessing the TPO recomputed the TP adjustment to ₹ 56,71,72,441 and the assessing officer by passing the final assessment order recomputed the disallowance on software expenses thereby the final assessed income was arrived at Rs.296,20,00,306. Aggrieved assessee is in appeal before the tribunal. The assessee has chosen Transactional Net Marginal Method (TNMM) to be the most appropriate method for determination of ALP. The operating profit and operating rate ratio has been taken as the profit level indictor in the TNMM analysis.

The TPO rejected the filters applied by the assessee and proceeded to apply new filters and selected comparables and then the TPO computed the TP adjustment. The learned A.R., with regard to the exclusion of the 4 comparable companies, submitted that all the four exclusions sought by the assessee is covered by the decision of the coordinate bench of the tribunal in the case of Yahoo Software Development (India) Pvt. Ltd. (2020) 115 taxmann.com 60 (Bang Trib). The ld AR further submitted that the reasons for exclusion of these companies by TPO/DRP is similar to the above case and therefore submitted that the decision of the coordinate bench in Yahoo Software (supra) is applicable in assessee’s case also.

The Hon’ble ITAT observed that the coordinate bench of the tribunal in the case of Yahoo Software Development (India) Pvt. Ltd (supra) has considered exclusion of the four comparable companies contended by the assessee and has held that the four companies shall be excluded. With regard to inclusion of 3 comparable companies as sought by the assessee the learned A.R. submitted that these companies have been held to be included as comparables in the decision of the coordinate bench of the tribunal in the case of Goldman Sachs Services Pvt. Ltd. (IT(TP)A No. 2355/Bang/2019. The Hon’ble ITAT followed the same and remit the matter of inclusion of the above three comparable companies to the file of TPO/A.O for examination.

On another issue of Capitalisation of Software Expenses, the assessee during the year under consideration has remitted a sum of Rs.1,78,18,565/- as expenses incurred towards software purchases. The AO disallowed the said amount by stating that the software purchases are perpetual and gave benefit of enduring nature to the assessee and should be treated as capital in nature. The AO allowed depreciation on the software treated capital in nature for an amount of Rs.89,78,862/- thereby making a disallowance of Rs.97,39,701/-. The DRP directed the AO to examine the nature of expenditure and if it is found that the expenses incurred were towards renewal of licence for application software for a period less than one year, the same may be allowed and if it is more than one year the same may be capitalised and depreciation can be allowed. Accordingly the AO called for the relevant details from the assessee and on perusal found that the software licence for an amount of Rs.18,15,263/- is for a period of less than one year and allowed the same as revenue expenditure as per the directions of the DRP and recomputed the disallowance accordingly.

The Hon’ble ITAT while placing its reliance in the case of CIT vs. IBM India Ltd. (2014) 43 taxxman.com 470 (Kar), wherein Hon’ble Karnataka High Court has dealt with the issue of payment made towards purchase of application software and have observed that the distinction of capital or revenue should be based on whether it is a system software or application software. Therefore it was that the distinction made by the DRP/AO based on the period of license is not tenable. The software purchased is system software or application software needs to be factually examined and therefore the matter was remitted to the AO.

Accordingly, the appeal of the assessee was partly allowed.

FULL TEXT OF THE ORDER OF ITAT BENGALURU

This appeal is against the final assessment order passed by Joint Commissioner of Income Tax, Special Range -3, under Section 143(3) r.w.s. 144C(13) of the Income Tax Act, 1961 (the Act) dated 21.10.2019 for AY 2015-16.

2. The assessee raised grounds pertaining to the following issues: –

i. Ground Nos. 1 & 2 are general

ii. Ground No. 3: Rejection of the Transfer Pricing Study of the assessee.

iii. Ground No. 4: Use of multiple year data

iv. Ground No. 5: Filters and qualitative criteria applied by the appellant

v. Ground No. 6: Use of Information gathered under section 133(6) of the Act is inappropriate to object or reject the TP study undertaken by the appellant.

vi. Ground No. 7: Working capital adjustment and risk adjustment

vii. Ground No. 8: Other transfer pricing related grounds

viii. Ground No. 9: Assets received on free of cost basis

ix. Ground No. 10: Capitalization of software expenditure

x. Ground No. 11: Other matters

3. With regard to TP adjustment, out of the various grounds raised,during the course of hearing the learned A.R. pressed for exclusion and inclusions of certain comparables as listed below and also working capital adjustments:

Exclusions

(a) Mindtree Limited

(b) Larsen & Toubro Infotech Limited

(c) Persistent Systems Limited

(d) Infosys Limited

Inclusions

(a) I2T2 India Limited

(b) Evoke Technologies Limited

(c) Melstar Information Technologies Limited.

4. The assessee is a private limited company and is the wholly owned subsidiary of Compaq Computer Holdings Ltd., Mauritius and is ultimately held by Hewlett Packard Company, USA. The assessee is engaged in the business of providing software development support services in the field of e-commerce, e-solutions, e-services, internet security and management etc. to its AEs. During the year under consideration the assessee filed return of income on 29.11.2015 declaring total income of Rs.197,11,40,320/- under normal provisions of the Act and book profits u/s.115JB of the Act at Rs.213,86,35,291. The case was selected for limited scrutiny under CASS and notice under Section 143(2) of the Act was duly served on the assessee. Since the assessee had international transactions the case was referred to the Transfer Pricing Officer (TPO) to determine the arm’s length price (ALP) of the international transactions the assessee has entered into with its Associate Enterprises (AE). The TPO made an adjustment of Rs.88,57,09,275/-. The Assessing Officer passed the draft assessment order incorporating the transfer pricing adjustment. The Assessing Officer further made an adjustment under Section 28(iv) of the Act for an amount of Rs.42,06,52,318/- towards the assets received by the assessee free of cost from its AEs. The Assessing Officer further made disallowance towards software expenses though allowed depreciation on the software expenses including those treated as capital asset in earlier years thereby arriving at the assessed income of Rs.256, 82,16,330. Aggrieved assessee raised its objections before the DRP. The DRP partially accepted the plea of the assessing on selection of comparable companies for determination of operating profit margin and directed the assessing officer to verify the nature of expenditure claimed with respect to software packages. Subsequently giving effect to the directions of the DRP and considering the various details furnished by the assessing the TPO recomputed the TP adjustment to ₹ 56,71,72,441 and the assessing officer by passing the final assessment order recomputed the disallowance on software expenses thereby the final assessed income was arrived at Rs.296,20,00,306. Aggrieved assessee is in appeal before the tribunal.

5. During the year under consideration the assessee has entered into the following international transactions with its AEs: –

Nature of transaction	Amount (In INR)
Provision of Software development support services	13,234,958,165
Purchase of components	26,32,78,140
Purchase of Fixed Assets	1,156,495,151
Software development and IT Service charges	3,11,49,073
Legal, Professional and Consultancy Charges	1,452
Reimbursement of employee benefit expenses	38,92,22,909

6. The assessee has chosen Transactional Net Marginal Method (TNMM) to be the most appropriate method for determination of ALP. The operating profit and operating rate ratio has been taken as the profit level indictor in the TNMM analysis. The assessee computed its operating margin as below: –

Nature of Transaction	Amount (in Lakhs)
Revenue from Operations	1,32,349.58
Other Income	1,151.35
Total Operating Revenue (A)	1,33,500.93
Employee benefits expenses	77,091.80
Other Expenses	25,202.90
Depreciation expenses	9,435.13
Bank charges	37.48
Total Operating Expenses (B)	1,11,767.31
Net operating profit (A – B)	21,733.62
NCP – OP/OC – In %	19.45%

7. The assessee chose the following comparables whose margin is in the range of 4.68% (35^th percentile) to 18.98% (56^th percentile): –

Sl.No.	Company Name	NCP 2012-13	NCP 2013-14	NCP 2014-15	Weighted average
1	MinvestaInfotech Ltd.	3.14%	1.79%	3.21%	2.73%
2	T V S Infotech Ltd.	2.87%	3.74%	2.89%	3.14%
3	Akshay Software Technologies Ltd.	8.15%	1.84%	NA	4.68%
4	C G-V A K Software & Exports Ltd.	14.50%	9.60%	13.73%	12.60%
5	R Systems International Ltd.	13.80%	23.74%	NA	18,98%
6	Hellos & Matheson Information Technology Ltd.	16.96%	21.53%	NA	19.62%
7	R S Software (India) Ltd.	17.88%	24.33%	32.82%	25.09%

–

35th percentile	4.68%
50th percentile	12.60%
65th percentile	18.98%

Therefore the assessee concluded that the international transactions entered into with the AEs are within the arm’s length price.

8. The TPO rejected the filters applied by the assessee and proceeded to apply new filters and selected comparables: –

Sl.No.	Company Name	Financial Year wise OP/OC (%)
		2014-15	2013-14	2012-13	Average
1	Kals Information Systems Ltd.	5.77	16.94	13.51	11.88
2	E-Zest Solutions Ltd.	12.59	15.80	Fails Export Filter	14.05
3	CG-VAK Software & Exports Ltd.	19.87	13.81	22.07	18.50
4	Tata Elxsi Ltd. (Seg)	23.33	22.02	11.24	19.34
5	Rheal Software Pvt. Ltd.	2.76	36.64	No data in Public Domain	19.88
6	Mindtree Ltd.	20.55	21.18	19.75	20.55
7	Larsen & Toubro Infotech Ltd.	24.22	23.54	25.10	24.21
8	R S Software (India) Ltd.	32.66	24.14	17.44	24.82
9	Infobeans Technologies Ltd.	20.70	41.95	29.22	29.91
10	Persistent Systems Ltd.	31.11	35.44	28.20	31.69
11	Nihilent Technologies Ltd.	29.19	35.72	No data in Public Domain	32.21
12	Aspire Systems (India) Ltd.	30.98	38.04	No data in Public Domain	34.18
13	Inteq Software Pvt. Ltd.	31.16	45.00	Fails Employee cost filter	37.90
14	Infosys Ltd.	40.29	36.28	39.25	38.59
15	Thirdware Solution Ltd.	43.69	44.68	32.65	41.12
16	Cybage Software Pvt. Ltd.	68.17	68.82	60.81	66.27
	35th Percentile				20.55%
	Median				27.37%
	65th Percentile				37.90%

9. The TPO therefore computed the TP adjustment as per below working: –

SWD SEGMENT
Particulars	Formula	Amount (in Rs.)
Taxpayer’s operating revenue	OR	13,35,00,93,000
Taxpayer’s operating cost	OC	11,17,67,31,000
Taxpayer’s operating profit	OP	2,17,33,62,000
Taxpayer’s PLI	PLI=OP/OC	19.45%
35th Percentile Margin of comparable set		20.55%
Adjustment Required (if PLI<35th Percentile)		Yes
Median Margin of comparable set	M	27.37%
Arm’s Length Price	ALP=(1+M)*OC	14,23,58,02,275
Price Received	OR	13,35,00,93,000
Shortfall being adjustment	ALP-OR	88,57,08,275

10. The learned A.R., with regard to the exclusion of the 4 comparable companies, submitted that all the four exclusions sought by the assessee is covered by the decision of the coordinate bench of the tribunal in the case of Yahoo Software Development (India) Pvt. Ltd. (2020) 115 taxmann.com 60 (Bang Trib). The ld AR further submitted that the reasons for exclusion of these companies by TPO/DRP is similar to the above case and therefore submitted that the decision of the coordinate bench in Yahoo Software (supra) is applicable in assessee’s case also.

11. The learned D.R. supported the orders of the lower authorities.

12. We heard the rival submissions and perused the material on record. We notice that the coordinate bench of the tribunal in the case of Yahoo Software Development (India) Pvt. Ltd (supra) has considered exclusion of the above four comparable companies contended by the assessee and has held as under: –

Mindtree Ltd.

“41. The next company sought to be excluded is Mindtree Ltd. The submissions made before us were as follows:-

“Functionally dissimilar, diversified operation, significant R&D spend, ownership of intangibles.

–  Also engaged in business of rendering IP-Led revenue, infrastructure management, package implementation, consultancy services, etc. constituting 45% of overall revenue during FY 2014-15.

– Diversified operation i.e. engaged in infrastructure management services, business process management, technology consulting, product engineering and SAP services. Also lacks segmental data.

– Significant research & development activity. By incurring R&D expenses, it was able to deliver IP based video surveillance management, recording and analytic products and solutions. It has filed 4 patents in India and US so far in the area of Video analysis.

–  Ownership of intangibles in the form of intangible property.

Significant on site activity:

–  46% of revenue earned under Onsite model.

–  Incurred overseas branch office expenses amounting to INR 1582 crores

–  Receives incentives from State of Florida in relation to the development center located overseas.

Lack of segmental data

–  Does not maintain segmental information in respect of profitability reported from business activities in the nature of infrastructure management services, technology consulting and SAP services.

–  Acquisition of subsidiary – Discoverture Solutions LLC.

42. The DRP while dealing with the aforesaid objections has merely taken the view that the presence of IPR revenue was insignificant and so also expenses of brand value, R&D & intangibles. More importantly, the DRP did not dispute the presence of 46% of revenue from onsite model, but went on to hold that the presence of revenue is not sufficient to exclude a company, when it is otherwise functionally comparable. On this aspect, we have already referred to the decision of the ITAT Bangalore Bench in the case of Trilogy e-business Software India (P) Ltd. (supra) and in the light of this decision and the admitted factual position regarding presence of onsite revenue over and above the threshold limit of 25% of total revenue, we are of the view that this company should be excluded from the list of comparable companies. We hold and direct accordingly.”

Larsen & Toubro Infotech Limited

38. As far as L&T Infotech Ltd. is concerned, the Id. counsel for the assessee brought to our notice the decision of ITAT Delhi Bench in the case of Saxo India (P.) Ltd. v. Asstt.CIT [2016] 67 taxmann.com 155, wherein the Tribunal took note of the fact that this company was also trading in software and owned insignificant intangible assets. The company was excluded from the list of comparable companies with reference to SWD services provider such as the assessee. The ld. Counsel pointed out that though this decision was rendered with reference to AY 2011-12, the same reasoning would apply to AY 2015-16 also and in this regard, he drew our attention to page 696 of assessee’s PB, which gives the details of the revenue generated by this company without any segmental break-up. Our attention was also drawn to page 682 of PB which shows that there is substantial onsite revenue activity as well as cost incurred on onsite software development. We notice from page 676 of assessee’s PB that this company as part of its operating profit in Schedule-O of profit & loss account contains expenditure for ‘cost of bought out items for resale’ and this is a significant part of the operating expenditure. When we see the revenue in Schedule M of the profit & loss account, there is no break-up of the revenue with regard to software services and software product. In our opinion, this distinction is enough to exclude this company from the list of comparable companies as held by the Hon’ble Delhi ITAT in the case of Saxo India (P) Ltd. (supra) which decision was also confirmed by the Hon’ble Delhi High Court.

Persistent Systems Ltd

32. At the time of hearing, the ld. counsel for the assessee has prayed for exclusion of 4 comparable companies that remain after the order of the DRP viz., Persistent Systems Ltd., Infosys Ltd., Mindtree Ltd. and L&T Infotech Ltd. He brought to our notice that as far as Persistent Systems Ltd. is concerned, the reasoning given for excluding this company for AY 2014-15 will equally hold good for the present year as well. In this regard, our attention was drawn to page 601 of the assessee’s PB wherein in the annual report of this company, Notes forming part of financial statement in note (i) which gives the description of income from software services, there is a reference to revenue from licensing & software, which sufficiently indicates that the assessee is not a pure SWD services provider. It was also brought to our notice that the profit & loss account which is at page 596 read with notes forming part of the financial statement at page 604 wherein the segmental reporting is not based on different segments and the statement presents a consolidated financial statement without any segmental reporting. This company has also significant RPT transaction of 25% on sales. He pointed out that the TPO & DRP on the application of RPT filter has not expressed any opinion. The ld. DR relied on the order of DRP wherein the DRP has made extensive reference to each of the objections regarding absence of segmental revenue in the accounts and has also noticed that the software products segment had an insignificant revenue and that the ownership of intangibles by the assessee has had no effect whatsoever.

33. We have considered the rival submissions. We find that on the question of application of RPT filter, the assessee had made the following submission before the DRP:-

4. Fails the Related Party Transaction to Sales filter applied by the learned TPO

In the show-cause notice issued, the learned TPO has excluded companies for which the ratio of RPT to sales exceeds 25% during the current year i.e., during FY 2014-15. The relevant extract from the show-cause notice is reproduced below for ease of reference:

(e) Companies who have more than 25% related parry transactions of the sales were excluded.

Companies having related party transactions of more than 25% are proposed to be excluded. A threshold of 25% is being applied following the provisions of Section 92A(2)(a) which provides a limit of 26% of the equity capital carrying voting rights for treating an enterprise as Associated Enterprise. if the limit is reduced further it would only result in eliminating more and more companies, on the other hand if the limit is relaxed then companies with predominantly related party transactions would get included which would not represent uncontrolled transactions. Therefore, on a balancing note, 25% is a proper threshold limit for related party transactions. The companies having more than 25% related party transactions should therefore be rejected as comparables.

The Hon’ble ITAT has upheld the application of this filter by the TPO in its order in the case of M/s. Supporisoft India Pvt. Ltd for AY 2005-G6 in IT (TP)A 1372/B/11 & 20/2012 dated 28-3-2013 following its own decision in the case of M/s. Actis Advertisers Pvt. Ltd vide ITA No. 5277/De1/2011 dated 12­10-2012.

On perusal of the Annual Report of Persistent, we observe that the company has RPT in excess of 25% of the sales. The calculation of the same has been provided below for your ease of reference:

R PT to Sales ratio for FY 2014-15 Particulars	Amount(INR Million)
Sale of services	2,410.02
Commission received	10.26
Purchase of software	1.49
Cost of technical professional	1,339.1
Commission paid on sales	111.79
Traveling and conveyance	19.27
Total related party transactions (A)	3,891.93
Total Sales (B)	12,424.98
RPT % of Sales (A/B)	31.32%

From the above computation, it is clear that the controlled transactions of Persistent constitutes 31.32% of sales. Based on the above, it can be seen that Persistent fails the `RPT to sales ratio’ filter applied by the learned TPO and should therefore not be considered as a comparable.”

34. This argument has been addressed by the DRP in its order as follows:— “4.4.9 We note that the approach of the TPO in treatment of related party transaction into two sets, are for revenue transactions and other for expense transaction is logical and correct. We also note that the RPT filter was adopted by the TPO was with the above conditions and has adopted consistently. Hence, we do not find any infirmity in the approach. Hence, we reject the assessee’s plea. We hold that on-site expenses do not adversely affect comparability and hence, such plea is rejected.”

35. Further, the assessee had also raised plea with regard to on-site revenue filter by pointing out that on-site revenue is substantial and therefore this company should not be regarded as a comparable company with a company which does not have any on-site revenue. In this regard, the ld. counsel for the assessee placed reliance on the decision of the ITAT Bangalore Bench in the case of Trilogy e-business Software India (P.) Ltd. v. Dy. CIT [2013] 29 com 310/140 ITD 540 wherein this Tribunal took the following view:-

“64. The next objection of the Assessee is that when the most appropriate method selected for determining ALP is the TNMM there is no reason as to why one should look at price difference in offshore software development and onsite software development. It is no doubt true that in TNMM it is only the margins in an uncontrolled transaction that is tested with reference to the controlled transaction but it is not possible to ignore the fact that pricing will have an effect on the margins obtained in a transaction. The argument that if pricing structure were to be considered as criteria, then it will have to be seen as to what is the pricing structure of all the comparable for various projects cannot be accepted because the TPO has not chosen any other onsite software service provider with a revenue composition of more than 75% from onsite software services as comparable. As rightly observed by the TPO, the pricing is different in onsite when compared to offshore operations. The further observations of the TPO that the reasons for the same lie in the fact that while in the case of OFFSHORE projects most of the costs are incurred in India; an ONSITE project has to be carried out abroad significantly increasing the employee cost and other costs.

65. The next objection of the Assessee is with regard to Assets employed. The companies, which predominantly generate revenues from onsite activity, do not have significant assets as most of the work is carried on the site of customer outside India. The argument that the TPO has himself observed that software service providers do not require much assets cannot be basis to accept the Assessee’s plea. Those observations are made by the TPO in the context of application of turnover filter and have been quoted out of context by the Assessee.

66. The next argument of the Assessee is that TPO has held that margins are lower in onsite software services and that margin is not a criteria to select or reject a comparable under Rule I0B(2) of the I.T. Rules. We are of the view that this argument again ignores the fact that the approach of the TPO has been to highlight the fact that there can be no functional comparability, if the assets employed and risks assumed are taken into consideration. It is in that context the TPO has referred to the margins.

67. The companies who generate more than 75% of the export revenues from onsite operations outside India are effectively companies working outside India having their own geographical markets, cost of labour etc., and also return commensurate with the economic conditions in those countries. Thus assets and risk profile, pricing as well as prevailing market conditions are different in predominantly onsite companies from predominantly offshore companies like the taxpayer. Since, the entire operations of the tax payer are taking place offshore i.e. in India; it is but natural that it should be compared with companies with major operations offshore, due to the reason that the economics and profitability of onsite operations are different from that of offshore business model. As already stated the Assessee has limited its analysis only to functions but not to the assets, risks as well as prevailing market conditions in which both the buyer and seller of services located. Hence, the companies in which more than 75% of their export revenues come from onsite operations are to be excluded from the comparability study as they are not functioning in similar economic circumstances to that of the tax payer. Hence, it is held that this filter is appropriately applied by the TPO.

68. Admittedly the onsite revenue in the case of the following comparable companies identified by the Assessee was more than 75% of its export revenues viz., a) Visu International Ltd. b) Maars Software International Ltd. c) Akshay Software Technologies Ltd. d) VJIL Consulting Ltd. e) Synfosys Business Solutions Ltd. The above companies were therefore rightly not considered as comparable by the TPO. We hold accordingly.”

36. It is seen that the TPO in coming to the conclusion that the onsite revenue filter is not applicable has placed reliance on the decision of the ITAT Mumbai Bench in the case of Capegemini as quoted in para 16 in para 14 of the TPO’s order, but that decision does not deal with a case of on-site revenue filter and the decision was rendered on the facts of its own case.

37. On the issue of RPT filter, we notice that the TPO in para 16 has accepted that the RPT filter should be @ 25%. In the case of Persistent Systems Ltd., the RPT is at 31.32% as extracted in the earlier part of this order and therefore this company should be excluded by application of RPT filter. In view of the above, we do not wish to go into other grounds on which this company is sought to be excluded viz., that it is a product company and there is no segmental data between product and services segment, presence of onsite activity and the impact of extra- ordinary event of acquisition during the relevant previous year. Therefore, this company is directed to be excluded from the list of comparable company.

Infosys Ltd.

39. The next company which the assessee seeks to exclude is Infosys Ltd. As far as this company is concerned, it is seen that the following are the functional dissimilarities brought to our notice:-

“Functionally dissimilar – owns intellectual properties, incurs significant R&D costs & onsite activity.

–   Engaged in diversified business activities.

–   Involved in development of software products in addition to software services.

–   Owns intellectual property rights.

–   Incurs significant research and development costs.

–   Carries out significant activities based on onsite business.

– Owns products such as Finacle, Edge Verve and other product based solutions.

Extra-ordinary event of merger with Infosys Consulting India Ltd.

Segmental profit & loss account not available.

Commands substantial brand value.

40. The DRP, however, has not thought it fit to exclude this company by observing that this company has substantial pre-dominant revenue from software services and the growth was not attributable to any brand value. Presence of onsite activity and the expenses on R&D have all been brushed aside. In our view, the difference pointed out by the ld. counsel for the assessee before us show that this company cannot be compared with that of the assessee basically because of its business model, presence of onsite revenue generation and other reasons cited before us. Besides, the reason that turnover of this company is huge and more than 10 times that of the assessee.”

Respectfully following the decision of the coordinate bench we hold for exclusion of the above four comparable companies.

13. With regard to inclusion of 3 comparable companies as sought by the assessee the learned A.R. submitted that these companies have been held to be included as comparables in the decision of the coordinate bench of the tribunal in the case of Goldman Sachs Services Pvt. Ltd. (IT(TP)A No. 2355/Bang/2019.

14. We heard the learned D.R.We notice that the coordinate bench of the tribunal in the case of Goldman Sachs Services Pvt. Ltd. (supra) has considerd the issue of inclusion of the following comparables and held that –

“(i) I2T2 India Limited – The LdAr submitted that the comparable company margin is 3.67%.The comparable has to be included as the RPT details are available in the Annual Report and referred to page no 2385 of the Paper Book. We are of the opinion that the Assessing Officer could have called for the information under Section 133(6) of the Act to confirm the details in the proceedings. Accordingly, we restore this comparable to the file of the TPO/A.O. for examination and verification of facts.

(ii) Evoke Technologies Limited – has margin of 0.53%. The LdAr submitted that the company is functionally comparable and passes all the TPO’s filters. The branch is a sub-set of an entity and the results of the branch are included in the audited financial statements of the entity and qualify export revenue, as the company is in the business of software development services and implement services. The LdAr has supported his arguments with the Paper Book at page no 2452 and Profit and Loss Account. Whereas the DRP has commented that unaudited accounts cannot be relied. The learned Authorized Representative relied on the decision of Nokia Seimens Networks India (P) Ltd. Vs. ACIT 70 taxmann.com 236 (Del), with observations at page 5 as under :

• • Undisputedly the TPO has used segmental data of this comparable company relating to software development profit segment provided to him under Section 133(6), which cannot be doubted without any cogent material brought on record by the assessee-company. Profit & loss account of this comparable company apparently proves the profitability of software development services segment. Segmental data obtained by the TPO though not audited but to convert this data, the assessee had not produced any material on record and as such, this company is a valid comparable for TP adjustment in this case

Considering the facts and submissions, we restore the comparable to the file of Assessing Officer for examination and verification of the facts and material.

(iii) Mel star Information Technology Limited margin is 5.29%. The company has made profit in the current year and not a loss making company. Whereas the DRP has rejected the company, which has incurred loss in two years out of three years. But for all the past years, the TPO had applied benchmark of rejecting companies with loses for all three years.”

11. The learned Authorised Representative relied on the decision of CIT v. Goldman Sachs (India) Securities (P.) Ltd. [2016] 69 com 19/240 Taxman 736 (Bom.) and Star International Movies Ltd. v. Dy. CIT [2019] 112 taxmann.com 258 (Mum.). In the case of Goldman Sachs India Securities (P) Ltd. (supra) in paras 4(a) and 4(b) the observations are read as under :

4. (a) The Respondent-Assessee urged before the Tribunal that the upward adjustment of Rs. 1.60 Crores by the TPO pertaining to Business Support Services rendered to its AL was, inter alia, on the basis of having rejected one of the comparable namely Capital Trust Limited, chosen by the Respondent-Assessee. This was rejected on account of the fact that Capital Trust Limited is a loss making unit. Before the Tribunal, the Respondent-Assessee; contended that the nature of business as carried out by the Capital Trust Ltd., and that carried out by the Respondent-Assessee are similar. Therefore it ought to have been included in as comparable to arrive at the ALP;

(b) The Revenue on the other hand contended that Capital Trust Limited is a persistent loss making unit and, thus, cannot be used as a comparable for the purpose of determining the ALP. The Tribunal by the impugned order held on a finding of fact that for the Assessment Year 2005-06 – Capital Trust Ltd. has made a profit although it made a loss for the subsequent two years namely Assessment Years 2006-07 and 2007-08. However, the impugned order of the Tribunal inter alia relies upon its order in the case of Brigade Global Services (P.) Ltd. v. ITO [2013] 33 taxmann.com 618 (Hyd. – Trib.) rendered by the coordinate Bench at Hyderabad- wherein it is held that only persistently loss making unit cannot be said as comparable. In this case, the impugned order holds on facts that Capital Trust Ltd. it is not a persistent loss making unit. Therefore, Capital Trust Ltd. is comparable; and

12. We, considering the facts, circumstances and judicial decisions are of the opinion that the disputed issue in respect of losses of continuous three years has to be verified/tested by the Assessing Officer. Accordingly we remit this matter to the file of TPO/A.O for examination.

15. Respectfully following the decision of the coordinate bench we remit the matter of inclusion of the above three comparable companies to the file of TPO/A.O for examination.

Working Capital Adjustment

16. The TPO while computing the TP adjustment did not consider the working capital adjustment. The learned A.R. in this regard submitted that it is an accepted principle held in various decisions of this tribunal that working capital adjustment should be allowed on actuals. The learned A.R. also submitted that all the relevant details submitted with regard to working capital has not been considered by the AO/DRP. The learned A.R. placed reliance in this regard on the decision of the coordinate bench of this tribunal in the case of Huawei Technologies India Pvt. Ltd. vs. JCIT (2019) 101 com 313 wherein it has been held that working capital adjustment is to be granted in actual. We notice that the coordinate bench of the tribunal in the case of Huawei Technologies has dealt with similar issue and held as under: –

10. The next grievance projected by the Assessee in its appeal is with regard to the action of the CIT (A) in not allowing any adjustment towards working capital differences. On this issue we have heard the rival submissions. The relevant provisions of the Act in so far as comparability of international transaction with a transaction of similar nature entered into between unrelated parties, provides as follows:

Determination of arm’s length price under section 92C.

10B. (1) For the purposes of sub-section (2) of section 92C, the arm’s length price in relation to an international transaction [or a specified domestic transaction] shall be determined by any of the following methods, being the most appropriate method, in the following manner, namely ;-

(a) to (b)**

(e) transactional net margin method, by which,-

(i) the net profit margin realised by the enterprise from an international transaction [or a specified domestic transaction] entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base;

(ii) the net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base;

(iii) the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction [or the specified domestic transaction] and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market;

the net profit margin realised by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii);

the net profit margin thus established is then taken into account to arrive at an arm’s length price in relation to the international transaction [or the specified domestic transaction);

(f) **                                                                                **

(2) For the purposes of sub-rule (1), the comparability of an international transaction [or a specified domestic transaction] with an uncontrolled transaction shall be judged with reference to the following, namely:-

(a) the specific characteristics of the property transferred or services provided in either transaction;

(b) the functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to the transactions;

(c) the contractual terms (whether or not such terms are formal or in writing) of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions;

(d) conditions prevailing in the markets in which the respective parties to the transactions operate, including the geographical location and size of the markets, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition and whether the markets are wholesale or retail.

(3) An uncontrolled transaction shall be comparable to an international transaction [or a specified domestic transaction] if-

(i) none of the differences, if any, between the transactions being compared, or .between the enterprises entering into such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from, such transactions in the open market; or

(ii) reasonably accurate adjustments can be made to eliminate the material effects of such differences.

11. A reading of Rule 10B(1)(e)(iii) of the Rules read with Sec.92CA of the Act, would clearly shows that the net profit margin arising in comparable uncontrolled transactions has to be adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, which could materially affect the amount of net profit margin in the open market.

12. Chapters I and III of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (hereafter the “TPG”) contain extensive guidance on comparability analyses for transfer pricing purposes. Guidance on comparability adjustments is found in paragraphs 3.47-3.54 and in the Annex to Chapter III of the TPG. A revised version of this guidance was approved by the Council of the OECD on 22 July 2010. In paragraph 2 of these guidelines it has been explained as to what is comparability adjustment. The guideline explains that when applying the arm’s length principle, the conditions of a controlled transaction (i.e. a transaction between a taxpayer and an associated enterprise) are generally compared to the conditions of comparable uncontrolled transactions. In this context, to be comparable means that:

• • None of the differences (if any) between the situations being compared could materially affect the condition being examined in the methodology (e.g. price or margin), or
  • Reasonably accurate adjustments can be made to eliminate the effect of any such differences. These are called “comparability adjustments.

13. In Paragraphs 13 to 16 of the aforesaid OECD guidelines, need for working capital adjustment has been explained as follows:

“13. In a competitive environment, money has a time value. If a company provided, say, 60 days trade terms for payment of accounts, the price of the goods should equate to the price for immediate payment plus 60 days of interest on the immediate payment price. By carrying high accounts receivable a company is allowing its customers a relatively long period to pay their accounts. It would need to borrow money to fund the credit terms and/or suffer a reduction in the amount of cash surplus which it would otherwise have available to invest. In a competitive environment, the price should therefore include an element to reflect these payment terms and compensate for the timing effect.

14. The opposite applies to higher levels of accounts payable. By carrying high accounts payable, a company is benefitting from a relatively long period to pay its suppliers. It would need to borrow less money to fund its purchases and/or benefit from an increase in the amount of cash surplus available to invest. In a competitive environment, the cost of goods sold should include an element to reflect these payment terms and compensate for the timing effect.

15. A company with high levels of inventory would similarly need to either borrow to fund the purchase, or reduce the amount of cash surplus which it is able to invest. Note that the interest rate July 2010 Page 6 might be affected by the funding structure (e.g. where the purchase of inventory is partly funded by equity) or by the risk associated with holding specific types of inventory)

16. Making a working capital adjustment is an attempt to adjust for the differences in time value of money between the tested party and potential comparables, with an assumption that the difference should be reflected in profits. The underlying reasoning is that:

• • A company will need funding to cover the time gap between the time it invests money (i.e. pays money to supplier) and the time it collects the investment (i.e. collects money from customers)
  • This time gap is calculated as: the period needed to sell inventories to customers + (Plus) the period needed to collect money from customers – (less) the period granted to pay debts to suppliers.”

14. Examples of how to work out adjustment on account of working capital adjustment is also given in the said guidelines. The guideline also expresses the difficulty in making working capital adjustment by concluding that the following factors have to be kept in mind (i) The point in time at which the Receivables, Inventory and Payables should be compared between the tested party and the comparables, whether it should be the figures of receivables, inventory and payable at the year end or beginning of the year or average of these figures, (ii) the selection of the appropriate interest rate (or rates) to use. The rate (or rates) should generally be determined by reference to the rate(s) of interest applicable to a commercial enterprise operating in the same market as the tested party. The guidelines conclude by observing that the purpose of working capital adjustments is to improve the reliability of the comparables.

15. In the present case the TPO allowed working capital adjustment accepting the calculation given by the Assessee. The CIT (A) in exercise of his powers of enhancement held that no adjustment should be made to the profit margins on account of working capital differences between the tested party and the comparable companies for the following reasons:

(i) The daily working capital levels of the tested party and the comparables was the only reliable basis of determining adjustment to be made on account of working capital because that would be on the basis of working capital deployed throughout the year.

(ii) Segmental working capital is not disclosed in the annual reports of companies engaged in different segments and therefore proper comparison cannot be made.

(iii) Disclose in the balance sheet does not contain break up of trade and non-trade debtors and creditors and therefore working capital adjustment done without such break up would result in computation being skewed.

(iv) Cost of capital would be different for different companies and therefore working capital adjustment made disregarding this different based on broad approximations, estimations and assumptions may not lead to reliable results.

16. The CIT (A) also placed reliance on a decision of Chennai ITAT in the case of Mobis India Ltd v. Dy. CIT [2013] 38 com 231/[2014] 61 SOT 40. That decision was based on the factual aspect that the Assessee was not able to demonstrate how working capital adjustment was arrived at by the Assessee. Therefore nothing turns on the decision relied upon by the CIT (A) in the impugned order. In the matter of determination of Arm’s Length Price, it cannot be said that the burden is on the Assessee or the Department to show what is the Arm’s Length Price. The data available with the Assessee and the Department would be the starting point and depending on the facts and circumstances of a case further details can be called for. As far as the Assessee is concerned, the facts and figures with regard to his business has to be furnished. Regarding comparable companies, one has to fall back upon only on the information available in the public domain. If that information is insufficient, it is beyond the power of the Assessee to produce the correct information about the comparable companies. The Revenue has on the other hand powers to compel production of the required details from the comparable companies. If that power is not exercised to find out the truth then it is no defence to say that the Assessee has not furnished the required details and on that score deny adjustment on account of working capital differences. Regarding applying the daily balances of inventory, receivables and payables for computing working capital adjustment, the Delhi Bench of ITAT in the case of ITO v. E Value Serve.com [2016] 75 taxmann.com 195 (Delhi – Trib.). has held that insisting on daily balances of working capital requirements to compute working capital adjustment is not proper as it will be impossible to carry out such exercise and that working capital adjustment has to be based on the opening and closing working capital deployed. The Bench has also observed that that in Transfer Pricing Analysis there is always an element of estimation because it is not an exact science. One has to see that reasonable adjustment is being made so as to bring both comparable and test party on same footing. Therefore there is little merit in CIT (A)’s objection on working adjustment based on unavailable daily working capital requirements data. There is also no merit in the objection of the CIT (A) regarding absence of segmental details available of working capital requirements of comparable companies chosen and absence of details of trade and non-trade debtors of comparable companies as these details are beyond the power of the Assessee to obtain, unless these details are available in public domain. Regarding absence of cost of working capital funds, the OECD guidelines clearly advocates adopting rate(s) of interest applicable to a commercial enterprise operating in the same market as the tested party. Therefore this objection of the CIT (A) is also not sustainable.

17. In the light of the above discussion we are of the view that the CIT (A) was not justified in denying adjustment on account of working capital adjustment. Since, the CIT (A) has not found any error in the TPO’s working-of working capital adjustment, the working capital adjustment as worked out by the TPO has to be allowed. We may also add that the complete working capital adjustment working has been given by the Assessee and a copy of the same is at pages 173 & 192 of the Assessee’s paper book. No defect whatsoever has been pointed out in these working by the CIT (A). We may also further add that in terms of Rule 10B(1)(e) (iii) of the Rules, the net profit margin arising in comparable uncontrolled transactions should be adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions which could materially affect the amount of net profit margin in the open market. It is not the case of the CIT (A) that differences in working capital requirements of the international transaction and the uncontrolled comparable transactions is not a difference which will materially affect the amount of net profit margin in the open market. If for reasons given by CIT (A) working capital adjustment cannot be allowed to the profit margins, then the comparable uncontrolled transactions chosen for the purpose of comparison will have to be treated as not comparable in terms of Rule 10B(3) of the Rules, which provides as follows:

“(3) An uncontrolled transaction shall be comparable to an international transaction if-

(i) none of the differences, if any, between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or cost charged to paid in, or the profit arising from, such transactions in the open market; or

(ii) reasonably accurate adjustments can be made to eliminate the material effects of such differences.”

18.In such a scenario there would remain no comparable uncontrolled transactions for the purpose of comparison. The transfer pricing exercise would therefore fail. Therefore in keeping with the OECD guidelines, endeavor should be made to bring in comparable companies for the purpose of broad comparison. Therefore the working capital adjustment as claimed by the Assessee should be allowed. We hold and direct accordingly.”

17. Respectfully following the decision of the coordinate bench of the Tribunal we hold that the working capital adjustment as claimed by the assessee should be allowed.

18. Since the ld AR did not press for other TP related grounds the same are dismissed as not pressed.

19. The TPO is directed to recomputed the ALP in accordance with the directions given in this order.

Assets received free of cost / loan basis from AE – addition made u/s.28(iv)

20. During the course assessment proceedings the AO on perusal of thefinancials of the company noticed that the assessee has received tangible assets from the AEs on free of cost basis to the tune of Rs.42,06,52,318/-. The assessee submitted before the AO as under: –

The Company was primarily engaged in the business of providing testing and software development services to overseas affiliates in relation to certain upcoming hardware products of P Group such as servers, printers, notebooks, desktops etc. These products are manufactured and sold by other affiliates across the globe. The Company receives hardware products mentioned earlier in their prototype stage (primarily unfinished products) to undertake certain prescribed set of tests and software development functions as part of the services to be rendered to the overseas HP entities.

The prototype units supplied by the Overseas affiliates are primarily in the form of unfinished qoods/ semi-finished products and are meant for carrying out testing and software development activity only. We also wish to submit that the prototype units, not being in the nature of final products/ standard hardware products, do not have any identified value in the open market on as it is basis, and do not carry any commercial value for the Company. The values assigned are the values only for the limited purposes of custom clearance of These Units. As explained these are being supplied to the Company by the overseas affiliates just to ensure that software development work being undertaken are compatible to these upcoming products and also for testing that whether these prototypes would function as expected once they go in to production and get released as final products._ Most of the times. These prototypes are just modules of hardware.

Steps involved in supply of FOC units to the Company:

> Project manager from overseas affiliate (majorly USA) shares the details of the unit proposed to be sent for testing/software development purposes with part number.

> India customs values is incorporated in shipping documents for the parts proposed for shipment.

> After updating India customs values, shipment request is sent to HPISO to verify the details of assessable value for custom clearance purposes.

> Shipment is released to Freight Forwarder.

> Post arrival of shipment, the Bill of Entry (BOE) is filed.

> No duty is paid since HPISO operates as an Export Oriented Unit (EOU”)/Special Economic Zone (“SEZ”) Unit/Software Technology Park of India (“STPI”) Unit.

21. The AO rejected the submissions of the assessee and made an addition under Section 28(iv) of the Act on the following grounds: –

a) That the Assessee has not established that such Assets which have been received are used entirely and only for Software Testing and are basically Prototypes. No supporting evidences have been submitted nor the details filed prove their assertion in any manner. In fact the documents filed and discussed in the above paras goes on to prove otherwise.

b) The Assessee has also not placed any material on record to show the terms of Contract or agreement entered into between the Parent/AE before sending such Assets. It is not known a clear as to whether the Assessee had placed requisition for such items or the Parent/AE had on their own sent the Asses free of cost and for what purpose.

c) In the absence of anything, specific in writing, as to why such assets are being sent one can only conclude that the basic intention is to simply pass on certain benefits to the Assessee for better and smoother conduct of the work assigned to it and also to avail of any Customs/Import duty waiver.

d) It is thus certain that the Assessee would have enjoyed benefits emanating from the gifting of such assets mainly consisting of Printers, Scanners, Laptops, Adapters etc and hence the same is liable to be treated as Profit and gain u/s 28(iv) of the Act.

22. Therefore the AO treated the entire value of the assets imported by the assessee free of cost/loan basis as a benefit received u/s.28(iv) and added the same to the taxable income of the assessee

23. The DRP confirmed the addition made by the AO.

24. The learned A.R. reiterated the submission before the DRP.The learned A.R. submitted that the assets have been brought on loan basis for earlier years also and the Revenue has not made any addition towards the same in earlier assessment years. The assets imported on loan basis are required in India to undertake testing activity and in this regard the learned A.R. drew our attention to the e-mail communication between the assessee and the AE. (page 20-21 of paper book)It is further submitted that while dispatching the assets on loan basis the AE arises invoices on the assessee and the said invoice captures the reasons for shipping the unit where it is mentions as ROS and within the HP world COSA is acronym for an internal IT system for ordering and receipt of units between group companies free of cost or loan basis for testing and develop activities. The learned A.R. further submitted that post completion of the testing and development activities the hardware procured from the overseas entities on free of cost or loan basis is either returned to the overseas entity or destroyed as per the prevailing law in India. The learned A.R. also drew our attention to the fixed asset schedule as per the Financial Statement of the assessee (page 19 of paper book) to substantiate that the assets brought on loan basis have not been accounted in the books of account of the assessee and is shown by way of a note in the fixed asset schedule. Without prejudice the ld AR submitted that the AO should not have invoked provisions of Section 28(iv) on the entire amount of cost of assets as a taxable income in the hands of the assessee and should have added only the benefit derived on such transaction. It is also submitted that the benefit derived if it is to be taxed u/s.28(iv) then the same should be assessed proportionately over the period when the said assets were used by the assessee in rendering services to the AE.

25. The learned D.R. supported the orders of the lower authorities.

26. We have heard the rival contentions and perused the material on record. We noticed that the assessee has entered into a master service agreement with its AE for rendering software development and testing services in connection with the products manufactured by the HP group. According to the agreement the assessee is to conduct the development and testing activity on the units under production or upgrade after receiving such units from an affiliate. In order to perform the development and testing services the assessee need to work on these hardware units being manufactured by overseas affiliates and in this regard the assessee requests for certain units from its AE for completing the activity. This is substantiated by the e-mail communication as referred by the learned A.R. during the course of hearing. Therefore the contention that no benefit is derived by the assessee by importing the items free of cost or on loan basis cannot be accepted. Before proceeding further we will look at the provisions of Section 28(iv) which reads as under: –

“28.The following income shall be chargeable to income-tax under the head “Profits and gains of business or profession”,—

****

(iv) the value of any benefit or perquisite, whether convertible into money or not, arising from business or the exercise of a profession;”

27. From the above it is clear that the value of any benefit whether convertible into money or not arising from business is taxable. In assessee’s case the assets imported free of cost are used in the testing services provided by the assessee to its AE thereby deriving the benefit of rendering billable services to the AE. Therefore we see no error in the AO’s action of invoking Sectino 28(iv) of the Act is correct.

28. However we notice that the AO has treated the entire value of the assets as the benefit derived under Section 28(iv) of the Act is not right since entire value of the assets cannot be said to be the benefit derived. It is the benefit that the assessee derived out of using the imported assets free of cost that need to be taxed under Section 28(iv) of the Actand this needs to computed based on the details and evidences in this regard. Further we notice that both the AO and DRP have made the addition based on the reason that the assessee has not submitted the relevant documentation to understand the terms and conditions of the arrangement with the AE and have not examined the issue factually. Therefore we remit this issue back to the AO to compute the value of benefit that the assessee derived by import of the assets free of cost or loan basis. The assessee is directed to submit all the relevant details before the AO in order to arrive at the benefit derived by the assessee in this regard. It is ordered accordingly.

29. During the course of hearing the learned A.R. presented various arguments with regard to the legality of the AO making a disallowance towards international transactions of import of assets free of cost from the AE. Since we have considered the issue on merit and have remitted the issue back to the AO for arriving at the benefit derived by the assessee the legal contentions presented by the learned A.R. have become academic and does not warrant any adjudication.

30. The assessee raised additional ground with regard to the issue of AO invoking Section 28(iv) of the Act. In the light of decision in para25 above the additional grounds raised have become academic.

Capitalisation of Software Expenses

31. The assessee during the year under consideration has remitted a sum of Rs.1,78,18,565/- as expenses incurred towards software purchases. The AO disallowed the said amount by stating that the software purchases are perpetual and gave benefit of enduring nature to the assessee and should be treated as capital in nature. The AO allowed depreciation on the software treated capital in nature for an amount of Rs.89,78,862/- thereby making a disallowance of Rs.97,39,701/-. The DRP directed the AO to examine the nature of expenditure and if it is found that the expenses incurred were towards renewal of licence for application software for a period less than one year, the same may be allowed and if it is more than one year the same may be capitalised and depreciation can be allowed. Accordingly the AO called for the relevant details from the assessee and on perusal found that the software licence for an amount of Rs.18,15,263/- is for a period of less than one year and allowed the same as revenue expenditure as per the directions of the DRP and recomputed the disallowance accordingly.

32. Before us the learned A.R. submitted that in the case of application software it is a right to use which is being brought by the assessee and therefore cannot be treated as capital in nature. The learned A.R. submitted that the details of software purchases have been submitted before the lower authorities and this software expenses are incurred to carry on the day-to-day business operations of the assessee and are in the nature amount paid towards renewal of licence maintenance and support services etc. The Ld AR further submitted that the period of license cannot be the basis of treating the software purchase, since it is only the license use the software that is bought and therefore the software is not the asset that belongs to the assessee.

33. The learned D.R. supported the orders of the lower authorities.

34. We noticed that the Hon’ble Karnataka High Court in the case of CIT vs. IBM India Ltd. (2014) 43 com 470 (Kar) has dealt with the issue of payment made towards purchase of application software and assailed that :

10. The Tribunal, on consideration of the material on record and the rival contentions held, when the expenditure is made not only once and for all but also with a view to bringing into existence an asset or an advantage for the enduring benefit, the same can be properly classified as capital expenditure. At the same time, even though the expenses are once and for all and may give an advantage for enduring benefit but is not with a view to bringing into existence any asset, the same cannot be always classified as capital expenditure. The test to be applied is, is it a part of the company’s working expenses or is it expenditure laid out as a part of the process of profit earning. Is it on the capital layout or is it an expenditure necessary for acquisition of property or of rights of a permanent character, possession of which is condition on carrying on trade at all. The assessee in the course of its business acquired certain application software. The amount is paid for application of software and not system software. application software enables the assessee to carry out his business operation efficiently and smoothly. However, such software itself does not work on stand alone basis. The same has to be fitted to a computer system to work. Such software enhances the efficiency of the operation. It is an aid in manufacturing process rather than the tool itself. Thus, for payment of such application software, though there is an enduring benefit, it does not result into acquisition of any capital asset. The same merely enhances the productivity or efficiency and, hence, to be treated as revenue expenditure. In fact, this court had an occasion to consider whether the software expenses is allowable as revenue expenses or not and held, when the life of a computer or software is less than two years and as such, the right to use it for a limited period, the fee paid for acquisition of the said right is allowable as revenue expenditure and these softwares if they are licensed for a particular period, for utilizing the same for the subsequent years fresh licence fee is to be paid. Therefore, when the software is fitted to a computer system to work, it enhances the efficiency of the operation. It is an aid in manufacturing process rather than the tool itself. Though certain application is an enduring benefit, it does not result into acquisition of any capital asset. It merely enhances the productivity or efficiency and, therefore, it has to be treated as revenue expenditure. In that view of the matter, the finding recorded by the Tribunal is in accordance with law and does not call for any interference. Accordingly, the second substantial question of law is answered in favour of the assessee and against the Revenue.”

35. The DRP had given the direction to the AO to examine the software purchase and decide the allowability based on the period of license. The Hon’ble Jurisdictional High Court in the case of IBM India Ltd(supra) has laid down clearly that the distinction of capital or revenue should be based on whether it is a system software or application software. Therefore we hold that the distinction made by the DRP/AO based on the period of license is not tenable. The software purchased is system software or application software needs to be factually examined and therefore we remit the issue back to the AO. The AO is directed to verify the nature of software based on evidences submitted by the assessee and decide the allowability keeping in view the decision of the Hon’ble Karnataka High Court in the case of IBM India Ltd (supra). Needless to say that the assessee should be given a reasonable opportunity of being heard. This ground is allowed for statistical purposes.

36. Ground 11 is consequential and does not warrant separate adjudication.

37. In the result the appeal of the assessee is partly allowed.

Dictated and pronounced in the open Court on20th September, 2022.