Revenue recognition method followed consistently cannot be disturbed unless there is change in facts & circumstances

Red Hat India Private Limited Vs DCIT (ITAT Mumbai)

Upon careful consideration we find that assessee has been following consistent system of revenue recognition. The assessee is inter alia engaged in the business of marketing, promotion and sale of ‘Red Hat subscriptions’ to customers in Indian sub-continent to avail support services that are for the open source software system during the subscription period ranging from one to seven year, which is established by the special services agreement or contract.   As   per   the consistent policy of revenue recognition, the assessee accounts for the revenue for service which would be performed in future year in its books as unearned revenue. Assessee’s claim is that this practice by the Assessee in respect of accounting for the sale of subscription is in with Accounting Standard-9 issued by ICAI. In support of this it is submitted that for rendering of service AS-9 provides that revenue should either be recognized on straight line basis over a period in which services are proposed to be rendered. The Assessing Officer has tinkered with this regularly adopted system on the plea that no further services is required to be performed by the assessee, that there is no significant uncertainty existing regarding amount of consideration that will be derived. The Assessing Officer has also find fault with completed contract method claimed to have been followed by the assessee.

Assessee’s contention in this regard is that the assessee never claimed that it is recognizing revenue from subscription under completed service contract method rather it is following the percentage competition method for recognition of Assessee has further reiterated that the assessee has been regularly recognizing revenue over a period to which such subscription relates. It has been claimed that the said practice of recognizing revenue is in accordance with paragraph-7 of percentage complete method of AS-9. The assessee has further placed reliance upon the Income Computation and Disclosure Standard (ICDS) issued by the CBDT pursuant to section 145(2) vide Notification No. 21/2016 dated 29.9.2016 for the proposition that when services arc provided by indeterminate number of acts over a period of specified time. Revenue may be recognized on straight line basis over specified period. The assessee has further relied upon the analogy from recently introduced section 43CB. In the light of the above assessee’s contention is that subscription package agreed may involve various support services which cannot be predetermine. Recipient of service can raise queries numerous times during the tenure of agreement. Similarly, any correction bug fixes etc. can be required by the customers any time during the duration   of the agreement. In the light of the above submissions in our considered opinion the Assessing Officer has clearly erred in changing consistently followed method of revenue recognition adopted by the assessee. In the facts and circumstances elaborately dealt with above, we find due merits of the revenue recognition adopted by the assessee which is duly supported by mandate of AS-9 and other parameters referred above.

 We also note that it is also a settled law that unless there is change in the facts and circumstances or that it can be said that earlier adopted system was wrong, revenue recognition method cannot be disturbed. We note that such case exists here. In these circumstances, we set aside the order of the Assessing Officer and delete the addition in this regard.

FULL TEXT OF THE ORDER OF ITAT MUMBAI

This appeal by the assessee is directed against the order of the Assessing Officer passed under section 143(3) r.w.s.144C(1) of Income Tax Act, 1961 (hereinafter “the Act”) dated 27.12.2017 for assessment year 2014-15 passed pursuant to the direction of the Dispute Resolution Panel (DRP)-2, Mumbai, dated 27.09.2018.

2. The grounds of appeal read as under :

Transfer Pricing

Adjustment relating to international transaction pertaining to payment of royalty and service fee

1.1 The Ld. AO [along with the Learned Transfer Pricing Officer (‘Ld. TPO’)] under the directions of Hon’ble DRP erred on facts and in law in making adjustment of INR 527,664,612 based on recharacterization of transaction, ignoring the commercial and business aspect, and disregarding the law relating to determination of the arm’s length price under Rule 10B of the Income-tax Rules, 1962 (‘the Rules’)

1.2 The Ld. TPO and Hon’ble DRP erred on facts and in law, in not appreciating the business model followed by the Appellant. In doing so, have grossly erred in:

a) disregarding the ‘License and Service’ Agreement justifying the arm’s length nature of transaction of payment of “Royalty” and ‘Service fees’;

b) misinterpreting the payment of ‘service fees’ as a payment of ‘royalty’ based on its own conjecture and surmises, and ignoring the explanations offered by the Appellant;

c) disregarding the fact that the payment of ‘service fee’ was in connection with the support provided by AE directly to the end customers of the Appellant;

d) disregarding the fact that the Appellant acts as a limited risk distributor and earns assured margins on revenue in ‘Subscription segment’; and

e) disregarding the fact that due withholding taxes were deducted on the service payment made to the AE

1.3 The Ld. TPO and Hon’ble DRP confirming the Ld. TPO’s action erred on facts and in law in disregarding the Transactional Net Margin Method (TNMM) as the most appropriate method for determining the arm’s length price of payment of service fees and applying the ‘Other Method’ in contravention of Rule 10B of the Rules

Adjustment relating to international transactions pertaining to provision of software support services

1.4 On facts and in law, the Ld. AO erred in confirming the Ld. TPO’s action of rejecting Akshay Software Technologies Limited as comparable company despite this comparable being reinstated by the Hon’ble DRP and thereby, violating the provisions of Section 144C(10)of the Act.

1.5 The Ld. TPO and Hon’ble DRP confirming the Ld. TPO’s action erred on facts and in law in determining the arm’s length price for provision of software support services and thereby making an adjustment of INR 12,558,704 to the taxable income of the Appellant. In doing so, have grossly erred in

a) modifying the economic analysis carried out by the Appellant in the Transfer Pricing documentation without providing any cogent reasons;

b) rejecting various comparable companies selected by the Appellant in the Transfer Pricing Documentation and considering various comparable companies as comparable to the Appellant without appreciating that such comparable companies are functionally dissimilar to the Appellant; and

c) disallowing relevant adjustments as per the provisions of Rule 10B(1) and Rule 10B(3)

Adjustment relating to international transactions pertaining to provision of sales & marketing support services

1.6 The Ld. TPO and Hon’ble DRP confirming the Ld. TPO’s action erred on facts and in law in determining the arm’s length price for provision of sales and marketing support services and thereby making an adjustment of 1NR 2,034,038 to the taxable income of the Appellant. In doing so, have grossly erred in

a) modifying the economic analysis carried out by the Appellant in the Transfer Pricing documentation without providing any cogent reasons;

b) rejecting various comparable companies selected by the Appellant in the Transfer Pricing Documentation and considering various comparable companies as comparable to the Appellant without appreciating that such comparable companies are functionally dissimilar to the Appellant; and

c) disallowing relevant adjustments as per the provisions of Rule 10B(1) and Rule 10B(3)

Corporate tax

Additions on account of unearned revenue from subscription services of Rs. 18,54,92,479

2.1 The Ld. AO and Hon’ble DRP erred on facts and in law in making an addition of Rs. 18,54,92,479 pertaining to subscription services and forming part of the ‘unearned revenue’, disclosed in the liabilities side of balance sheet of the Appellant, as income of the current year, without appreciating the fact that the impugned amount is in the nature of advance and is not chargeable to tax in the current year;

2.2 The Ld. AO and Hon’ble DRP, while itself accepting the fact that the Assessee is following percentage completion method of revenue recognition for services as per Accounting Standard -9, issued by ICAI (AS-9), has erred on facts and in law making the addition on the erroneous premise that the completed contract method of revenue recognition is not applicable to the facts of the Assessee;

2.3 The Ld. AO and Hon’ble DRP erred in understanding the nature of services and the contractual framework between the Appellant and its customers and while doing so:

a) erred on facts in holding that the services are complete on entering of the subscription services agreement with the customer, without appreciating that the agreement is for rendering of services for a period which generally exceeds 1 year;

b) erred on facts in equating the income from services with sale of goods based on the incorrect premise that performance of the Appellant is complete on signing of the subscription services agreement; and

c) erred on facts in not appreciating that the Appellant is solely responsible for provision of services during the term of the subscription services agreement.

2.4 The Ld. AO and Hon’ble DRP erred on facts and in law in preponing the income to the current year, without appreciating that the books of accounts are duly audited and unqualified by the auditor, and the said income is offered to tax in the respective year in which it is accounted, thereby, it is revenue neutral;

2.5 Without prejudice to the above, the Ld. AO and Hon’ble DRP erred in not granting a corresponding deduction/relief of 1NR 18,28,95,584 on the preponment of income, for a corresponding increase in expenses in the nature of ‘royalty’ and ‘service fees’ payment as per the terms of the ‘License and Service’ agreement entered into by the Appellant with the AE and in view of the matching concept of accounting;

Other grounds

2.6 The Ld. AO erred in not considering the total income as per the revised return of income filed by the Appellant on 15 March 2016;

2.7 The Ld. AO erred in short granting credit of Taxes Deducted at Source to the extent of Rs. 5,55,907 while computing the tax liability for the year;

2.8 The Ld. AO erred in not granting credit of advance tax paid amounting to Rs. 2,42,00,000 while computing the tax liability for the year;

2.9 The Ld. AO erred on facts and in law in levying the interest under section 234B of the Act;

2.10 The Ld. AO erred on facts and in law in initiating penalty proceedings under section 274 read with section 271(l)(c) of the Act.

The Appellant craves leave to add to, or alter, by deletion, substitution, modification or otherwise, the above grounds of appeal, either before or during the hearing of the appeal.

3. Brief facts and the assessee’s main grievances are summarized in the following submission by assessee.

1.1. Business profile

• Red Hat US is a provider of open-source solutions for internet computing;
• An open source software typically grants every user free access to the source code and enable the customers to modify and customize the software to suit their requirements, unlike a proprietary software where source codes are owned by developers; #
• Once an open source software is downloaded, software users may require access to ongoing support services;
• The sale of ‘Red Hat subscriptions’ enable the customers to directly avail and access 24*7*365 support service from various support centres of Red Hat Group located in US, UK, Asia, Australia, Czech Republic, Africa, Russia and various language specific countries;
• The Appellant enters into an Enterprise Agreement with the customers and distributes the open source ‘Red Hat subscriptions’;
• Further, the Appellant provides Red Hat software training content to the customers/ Red Hat training partners for which Red Hat US offers various training courses, renders consultancy services for the application of the systems, etc.;
• Based thereon, the Appellant sub-contract services to Red Hat US vide a ‘License and Service Agreement’, pursuant to which the Global support service centres of Red Hat provide support services directly to customers;
• The abovementioned business activities can be classified under the following two segments o Subscription segment -Appellant sells Red Hat service offerings to customers in India;
• • Services segment – Appellant provides Red Hat training content to customers in India, Alongside, offers training and certification courses, etc.
• In consideration for such services, the Appellant compensates Red Hat US with: o royalty for use of intellectual property (trademark/ trade name); and o service fees for provision of support services directly to customers
• In addition to the above, the Appellant renders sales & marketing and software support service to AEs

1.2 Benchmarking methodology adopted in the TP Study

1.3 Actions of Ld. TPO and Hon’ble DRP

During the course of assessment proceedings, the Ld. TPO, as confirmed by Hon’ble DRP, made an adjustment to the income of the Appellant on account of the following:

• Disallowed the entire payment of service fees while alleging:
  • payment of ‘service fees” as a payment of “royalty’; and
  • without prejudice, the support services are provided by AE to the Appellant i.e. services in the nature of intra-group services, for which there is no proof of any services being rendered
• Proposed an adjustment under the sales & marketing support service segment and software support segment

In this respect, the Appellant wishes to place its arguments as under:

Ground 1.1 – 1.3: Adjustment on account of payment of service fees

2.1. Covered matter in preceding years i.e. AY 2012-13 & AY 2013-14 “

The Appellant wishes to submit that Hon’ble ITAT in Appellant’s own case of AY 2012-13 and AY 2013-14, on identical facts, has deleted the entire adjustment on account of payment of service fees.

There has been no change in the functions, assets, and risk profile of the Appellant in the impugned year and preceding two years. In this respect, the Appellant wishes to place reliance on the Hon’ble Mumbai ITAT judgment in its own case:

• • AY 2012-13 – ITA No. 1456/Mum/2017
  • AY 2013-14-ITA No. 727I/Mum/2017

The relevant extract of the Hon’ble Mumbai ITAT Judgment in Appellant’s own case of AY 2012-13 & AY 2013-14 is provided below:

’28. Upon careful consideration, we find that the actual payment for royalty and serivce fees both under subscription and services segment are as per the agreement entered into between the assessee and its AE, No fault in the computation thereof has been pointed by the Revenue. Only due to error entire payment was booked under royalty. The sole basis on which the adjustments has been made is that the entire payment has been booked under royalty and the difference between the royalty as per the agreement and the total amount paid has been disallowed by the Revenue Authorities. We find that this is totally de hors the substance of the transactions. It is settled law that it is the substance that counts and not the nomenclature given by the party. In this situation, the disallowance/ adjustment made by the TPO confirmed by the DRP is without any application of mind and the same cannot be sustained. Moreover, the assessee’s claim has been duly supported b}’ the certificate from the statutory auditor which has also been ignored by the authorities below, without assigning any reason for the same. In these circumstances, we are oj the considered opinion that the transfer pricing adjustment of INR 23,52,26,045 for AY 2012-13 and INK 27,70,02,848 for AY 2013-14 is unjustified and deserves to be deleted. We order accordingly.

29. As regards the submission of the Ld. DR that the matter be remanded to the TPO for examination of the issue, on the bench marking method applied by the assessee, we do not find any reason what so ever to give the TPO a second innings. The TPO despite being made aware that royalty and service fees are two aspects of the matter and the documentation were on record, refused to carry out the analysis. We find that the TPO was fully aware of the assessee’s arguments however there is no whisper by the authorities below of any shortcoming in this aspect. The Ld. DR has also not been able to point out any defect therein on the basis of the documents on record and the submissions of the assessee. It is neither the case that revenue has pointed out any defect in the documentation nor there is a case made out that there is a shortcoming in the selection of the comparables or the search process. In these circumstances, we do m./ find any reason to set aside the matter to Ld. TPO. Accordingly, we decline the request nude by the Ld. DR.’

The detailed arguments on merit, similar to previous years’, is attached as Annexure I,

Ground 1.4 – 1.5: Adjustment on account of provision of software support services

2.2. Non-grant of relief in the final assessment order

The Appellant wishes to submit that the Assessing Officer has erred in not considering the binding directions of the Hon’ble DRP in the final order, wherein Akshay Software Technologies Limited has been reinstated as a comparable in the final set.

In view of the directions of the Hon’ble DRP, the net cost plus mark-up of 15% earned by the Appellant for the provision of software support services falls within the +/-3% of arm’s length price earned by comparable companies as per the proviso to Sec 92C(2) of the Income Tax Act 1961.

The Appellant had filed an Appeal Effect Application before the Ld. TPO pursuant to DRP directions dated October 24, 2018(Refer Page 337 of Paper-book /)and then a Rectification Application and a follow-up thereon (Refer Page 379 and Page 417 of Paper-book I), wherein the Appellant had requested following the DRP directions, the adjustment on account of provision of software support services.

The arm’s length net cost plus mark-up (‘NCP’) of the final selected 6 comparable companies is provided below for your ready reference:

The NCP earned by the Assessee under the software development segment is provided below:

Based on the above results, NCP of 15% earned by the Assessee for the provision of software development service falls within the +/- 3% of the arm’s length price i.e. NCP of 17.75% earned by comparable companies. Accordingly, the same is consistent with the arm’s length standard from an Indian Transfer Pricing perspective.

Accordingly, no adjustment Js warranted as the same_ is consistent with the arm’s length standard from an India transfer pricing perspective.

In addition to the above, the detailed arguments on merit are attached as Annexure 2.

Ground 1.6: Adjustment on account of provision of sales & marketing support services

During AY 2014-15, the Appellant was engaged in providing sales & marketing support services, for which it was remunerated at a cost plus mark-up of 5%. The Ld. TPO, as confirmed by the Hon’ble DRP, computed the arm’s length mark-up at 10.78% and made an adjustment of INR 2,034,038. In this respect, the Appellant wishes to place its arguments, as under:

2.3 Appellant’s arguments on rejection/selection of comparables

2.4 Arguments for working capital adjustment to be allowed to the Appellant

The amount of capital required to support business functions varies greatly, because of the level of debtors and creditors. The effect on profits from investing in different levels of working capital must be taken into account.

Rule 10B(l)(e) and Rule 10B(3) of the Rules requires the difference between controlled and uncontrolled transactions should be taken into account for which necessary adjustments shall be made. OECD guidelines also points out the need to adjust comparables and the requirement for accuracy and reliability. The above is also supported by various judicial precedents, mentioned below, wherein it has been held that the working capital adjustment should be carried out to bring two otherwise comparable cases at par with each other.

• Nortel Networks India Private Limited v/s ACIT (ITA 4765/DEL/2011 & ITA 427/DEL/2013)
• TNT India Private Limited ACIT (ITA No. 1442 {BNG}/ 08)
• Federal Mogul Anand Bearing India Limited DCIT (ITA No. 463/Mum/2016)
• DCIT Exedy India Limited (ITA no.897/Mum/2018)
• Income Tax Office Smarsh India Private Limited (IT(TP)A No.847/Bang/2013)
• I apian India Ltd. vs. ITO (ITA No.-1481/Del/2015)

4. Per contra, Ld. DR relied upon the orders of the authorities below.

5. We have heard rival submissions and perused the material available on record. As regards, ground No.1-1.3 adjustment relating to international transactions pertaining to payment of royalty and service fee. It is noted that identical issue was decided by this Tribunal in assessee’s own case for AY 2012-13 and 2013-14. No distinguishing feature in the facts in the present year was pointed out by the revenue. It is also not the case that Hon’ble jurisdictional High Court has reversed the order of the ITAT. In this view of the matter following the decision of the co-ordinate bench in assessee’s own case, we set aside the Transfer Pricing Adjustment (TPA), in this regard and direct the same to be deleted.

6. As regards, the ground No.1.4-1.5, the same is in relationship to adjustment on account of provision of software support services. As noted above, it is the contention of the assesse that AO had not considering the binding   direction of DRP in the final order., wherein Akshay Software Technologies Limited has been reinstated as a comparable in the final set.

7. It is further contention that in view of the direction of the DRP, the net cost plus mark-up of 15% earned by the assessee for the provision of software support services falls within the +/-3% of arms’ length price earned by comparable companies as per the provision of section 92C(2) of the I.T.Act, 1961.

8. Further, Ld. Counsel of the assessee has submitted that when the AO does not follow the direction of the Ld.DRP, the entire assessment order is liable to set aside. Referring to above Ld. Counsel of the assessee has requested the entire assessment order to be quashed as such. Upon careful consideration, we are not at all in the agreement with the submission of the Ld. Counsel of the assessee that when a direction of the DRP is not followed on one of the issues the entire assessment order dealing with the several issues is liable to be quashed. It is settled law that there cannot be a disproportionate retribution. In this view of the matter, we are of the opinion that since, the AO has not followed the direction of DRP, the adjustment on account for provision of software support services is not sustainable and same is liable to be deleted. Accordingly, we direct the adjustment in this regard is to be deleted.

9. Apropos ground No. 1.6 relating to international transactions pertaining to provision of sales and marketing support services. In this regard, it is the contention of the Ld. Counsel of the assessee that during AY 2014-15, the assessee was engaged in providing sales & marketing support services, for which it was remunerated at a cost plus mark-up 5%. The TPO completed it at 10.78% and made an adjustment of Rs. 2,034,038/-. The assessee’s counsel has submitted that one of the comparable selected by TPO i.e Axis Integrated Systems Limited suffers from several dis- functionalities which has been reproduced the assessee’s submission herein above. The assessee’s contention is that if the same is removed from list of comparables selected by the TPO, the ALP margin will be appropriate and hence, no adjustment will be required. As noted above, this comparable suffers from following dissimilarities.

We find cogency in the above submissions, which are duly supported by the case laws. Hence, we direct that this comparable should be removed from the final set of comparables. The AO should make computation accordingly.

10. Apropos additions on account of unearned revenue from subscription services of Rs.18,54,92,479/-. At the outset, Ld. Counsel   of the assessee states that the issue is covered in favour of the assesse by ITAT order in assessee’s own case for AY 2012-13 & 2013-14. Upon careful consideration, we note that ITAT co-ordinate Bench vide order date for AY 2012-13 and 2013-14 in assessees own case has held as under:-

61. Upon careful consideration we find that assessee has been following consistent system of revenue recognition. The assessee is inter alia engaged in the business of marketing, promotion and sale of ‘Red Hat subscriptions’ to customers in Indian sub-continent to avail support services that are for the open source software system during the subscription period ranging from one to seven year, which is established by the special services agreement or contract.   As   per   the consistent policy of revenue recognition, the assessee accounts for the revenue for service which would be performed in future year in its books as unearned revenue. Assessee’s claim is that this practice by the Assessee in respect of accounting for the sale of subscription is in with Accounting Standard-9 issued by ICAI. In support of this it is submitted that for rendering of service AS-9 provides that revenue should either be recognized on straight line basis over a period in which services are proposed to be rendered. The Assessing Officer has tinkered with this regularly adopted system on the plea that no further services is required to be performed by the assessee, that there is no significant uncertainty existing regarding amount of consideration that will be derived. The Assessing Officer has also find fault with completed contract method claimed to have been followed by the assessee.

62. Assessee’s contention in this regard is that the assessee never claimed that it is recognizing revenue from subscription under completed service contract method rather it is following the percentage competition method for recognition of Assessee has further reiterated that the assessee has been regularly recognizing revenue over a period to which such subscription relates. It has been claimed that the said practice of recognizing revenue is in accordance with paragraph-7 of percentage complete method of AS-9. The assessee has further placed reliance upon the Income Computation and Disclosure Standard (ICDS) issued by the CBDT pursuant to section 145(2) vide Notification No. 21/2016 dated 29.9.2016 for the proposition that when services arc provided by indeterminate number of acts over a period of specified time. Revenue may be recognized on straight line basis over specified period. The assessee has further relied upon the analogy from recently introduced section 43CB. In the light of the above assessee’s contention is that subscription package agreed may involve various support services which cannot be predetermine. Recipient of service can raise queries numerous times during the tenure of agreement. Similarly, any correction bug fixes etc. can be required by the customers any time during the duration   of the agreement. In the light of the above submissions in our considered opinion the Assessing Officer has clearly erred in changing consistently followed method of revenue recognition adopted by the assessee. In the facts and circumstances elaborately dealt with above, we find due merits of the revenue recognition adopted by the assessee which is duly supported by mandate of AS-9 and other parameters referred above.

63. We also note that it is also a settled law that unless there is change in the facts and circumstances or that it can be said that earlier adopted system was wrong, revenue recognition method cannot be disturbed. We note that such case exists here. In these circumstances, we set aside the order of the Assessing Officer and delete the addition in this regard.

11. We find that DRP has followed its own order for AY 2013-14 which has already been set aside by ITAT as above. No case has been made out that facts in the present case are different. Hence, we set aside the order of authorities below and decide the issue in favour of assessee.

12. Apropos ground No.2.6 to 2.10, these are consequential grounds, we direct the AO to examining the submission of the assessee and decide as per law.

13. In the result, the appeal is partly allowed.

Pronounced in the open court on 29.06.2021