Case Law Details
Brief of the case
In the case of HCL Technologies BPO Services Ltd vs. ACIT, ITAT has held that for transfer pricing only amount retained by associates from end user is to be taken into account for transfer pricing adjustment, and to adjust operating cost by excluding abnormal cost incurred on a/c of Startup Company like salary, rent, and depreciation.
Facts of the case
1. The brief facts of the case are that the appellant is a private limited company and is engaged in providing IT Enabled Services (ITES) e.g. voice/web based contact and front office services (hereinafter referred as business process outsourcing (BPO) services). For the relevant previous year, the return of income of the appellant was filed declaring loss of Rs.12,85,57,867/-. The appellant had during the relevant previous year entered into the international transaction of provision of information technology enabled services, amounting to Rs.13,06,79,399/- with the various associated enterprises. For application of TNMM, the appellant was considered to be the tested party and operating profit/total cost was taken as the profit level indicator (PLI).
2. The operating results of the appellant were computed as follows:
| Operating income | 209,032,558 |
| Less: Operating expenses | |
| Personnel expenses | 13,38,59,484 |
| Administration selling & other | 15,13,90,147 |
| Finance charges | 7,68,060 |
| Depreciation | 4,42,53,507 |
| Miscellaneous expense written off | 37,71,203 |
| Total Operating Cost | 33,40,42,401 |
| Operating profit | (-)12,50,09,843 |
| Operating profit ratio | (-)37.34% |
3 .The assessee had conducted transfer pricing analysis by using multiple year data of previous financial year in which data of the 3 years is on actual basis and for 2 years on project basis. The appellant also selected the TNMM to determine the arms length price for the transactions with AE on transactions and for the application of TNMM, the appellant selected operating profit /on total cost was taken as profit level indicator (PLI).
4. For application of TNMM, the appellant identified the eight comparable companies engaged in rendering voice based I web based BPO/ITES. Further, the appellant considered the Profit Level Indicator (“PLI”), i.e., Operating Profit /Total Cost of the comparable companies for the financial years 2001-02 and 2002-03
5. The actual operating profits margin (OPITC) was· (-) 37.35% in the financial year 2002-03, (-)2.94% in 2003-04 and (+)20.94% in 2004-05. Further, the projected operating profits margin (OPITC) was 19.14% in the financial year 2005-06 and 18.29% in 2006-07. The weighted average operating margin or these five financial years was computed as 14.09%. The weighted operating” profit on total cost margin of 14-.09% during the abovementioned financial ears, being higher than that of the comparable companies at 13.56%, the “international transactions” of rendering business process outsourcing services were considered being at arm’s length.
6. On noting of above transactions, the A.O. made reference to transfer pricing officer. The Transfer Pricing Officer (TPO), however, in his order held that the arm’s length operating profit to the total cost ratio in the above business being 13.56%, viz., average operating profit / cost margin of 8 companies was considered as comparable by the TPO. The TPO accordingly, in the order passed under section 92CA(3) of the Act, determined adjustment of Rs. 17,03,05,993 to the arm’s length price of’ ‘international transactions’ of provision of business process outsourcing services applying TNMM,as under:
| Calculation of arm’s length price | Amount |
| Total operating cost Rs. | 33,40,42,401 |
| Arm’s length margin | 13.56% |
| Profit which the appellant would have earned Rs.33,40,42,401 | 13.56% |
| Rs. 4,52,96,150 | |
| Less: Operating loss posted by the appellant Rs. | (-)12,50,09,843 |
| Difference | Rs.17,03,05,993 |
7. The A.O. based on the report of TPO made addition of Rs.17,03,05,993/- on account of transfer pricing adjustment.
8. Aggrieved by the said order appeal was filed before Ld. CIT(A). It was submitted that from the gross revenue received from the end customers in respect of various contracts, the associated enterprise retained in aggregate only a sum’ of Rs.1,19,60,457 at their end the balance amount has been passed on to the appellant. Without prejudice to the assessee company’s contention that the adjustment made by the TPO in not sustainable, it was submitted that the adjustment at best could be made only to the extent of Rs. 11,960,457, being the amount which has been retained by the associated enterprise. Ld. CIT(A) accepted the plea of assessee company that Transfer Pricing Adjustment should be actually restricted to the amount actually retained by associated enterprises. And held as under
“The Transfer Pricing Officer has computed an adjustment of Rs. 17.04 crores while the value of international transactions is Rs. 13,00,89,632. The total revenue received by the associated enterprises in respect of BPO services rendered by the appellant amounting to Rs.13,00,89,632 is Rs.14,20,50,089. In other words, the associated enterprise has retained Rs. 1, 19,60,457 out of the total proceeds received from the customers. The adjustment computed by the TPO in the order passed under section 92CA(3) of the Act at best cannot exceed the net amount retained by the associated enterprises in respect ‘of international transactions, i.e., gross revenue’ received from the end customers less amount paid’ to the appellant and, other operating expenses. It is observed that the gross revenue received from the end customers in respect of various contracts, the associated enterprise have retained only Rs. 1,19,60,457 at their end and the balance has been passed on to the appellant.”
Aggrieved by the decision of CIT(A) Revenue and Assessee both are in appeal.
Issue
1. Whether on the facts and in the circumstances of the case, the CIT (A) has erred in law and on facts in restricting the addition of Rs.1703,05,993/- to Rs. 1,19,60,457/-made by the Assessing officer on the basis of adjustment computed by the TPO u/s 92CA(3) of the, specifically when the fact that when the com parables were making average profit @ 13.56% then the assessee would have earned the same profit in international transactions.
2. Whether the learned Commissioner of Income-tax (Appeals) erred both on facts and also in law in confirming the addition to the tune of Rs.l,19,60,457/- which the learned Transfer Pricing Officer (“TPO”) without appreciating fact that the approach which the appellant had adopted by taking a weighted average of its operating margins over a period of 5 years (including the impugned financial year) of business cycle and then comparing the same with the arithmetic mean of the companies selected as comparable companies for applying the TNMM as the most appropriate method is in conformity with the well established OECD guidelines in case of Start-up Companies.
Revenue’s Contention
1. DR relied on order of AO and TRO viz. In the transfer pricing approach the assessee has used data for five financial years out of which data of three years is on actual basis and for two years on projected basis. Such kind of approach permitting use of financial data for multiple years’ of the taxpayer for working operating profits is not provided in the Indian Transfer, Pricing regulations. The provisions of Rule 108(1)(e) of Income Tax rules contains method of application of Transactional Net Margin Method. It emphasizes use of data for the year in which transaction took place. It may further be mentioned that Rule 108(4) categorically restricts that the data for the comparables should be contemporaneous ‘and drily in exceptional circumstances data for two prior years can be used along with data for the year under consideration. In fact all the provisions emphatically and with no ambiguity cast an obligation of benchmarking transaction on the basis of information as close as possible to the year in which the with the AE(s)’ has been entered into international transaction. IT is understandable that since in. modern economics situations change so fast, use of non contemporaneous data can throw up slanted results.
In order to compare operating margins the assessee has used data of eight comparable companies using data’ for the year ending March 2002 and March 2003 in each case. The data for multiple years has been used on the argument that it is permitted as per rule 108(4) of Income tax rules. In this case since the assessee company is in its start up phase therefore special conditions of even out results of more than one year of financial performance exist as enshrined in proviso to the above said rule deserving use of financial data for the multiple year. Therefore, the approach of the assessee in respect of use of multiple year data of comparables is not disturbed. It is also not out of place to mention that the comparables used by the assessee company has functional and product differences with the assessee company but for the year under consideration these comparables are not being disturbed for the reasons that the assessee company has apparently chosen best possible comparables which could functionally take care of start up phase of the assessee company.
Assessee’s Contention
For Revenue appeal
1. that the appellant could not have expected to receive from the customers of the AEs of the appellant, anything more than the amount paid by some customer to the AE, if the appellant were to be obtain the contracts for services from the customers directly, i.e., without the involvement of the AEs of the appellant. Thus, at the most the consideration received by the appellant from the AEs may be replaced by the consideration received by the AEs from its customers, for the services provided by the appellant; the price charged by AEs to the customers being the CUP.
2. Reliance is placed on the decision of Delhi Bench of the Tribunal in the case of DCIT vs Global Vantedge P. Lid., (ITA No. 1432 & 2321/0ell2009 and 116/0eI/2011), wherein, the Hon’ble Tribunal held that adjustment on account of arm’s length price of international transactions cannot exceed the amount received by the associated enterprise from the customer and the actual value of international transactions, i.e., the amount received by the assessee in respect of international transactions. The Hon’ble Jurisdictional High Court vide order dated 14-03-2013 (in ITA Nos. 1828/2010, 1829/2010 & 1254/2011) had dismissed the Revenue’s appeal against the said order of the Tribunal. The Special Leave Petition (SLP) of the Revenue against the said order has also been dismissed by the Supreme Court vide order dated 02-01-2014 (CC No. 22166 of 2013).
3. Reliance is placed on following judgments:
a. Hon’ble Delhi bench of the Tribunal in the case of Li & Fung (India) Pvt. Ltd. vs. DCIT (ITA No 5156/DeI/2010)
b. Delhi Bench of the Tribunal in the case of Hyper Quality India Pvt. Ltd. vs. ACIT (ITA No. 5630/0ell2011 )
c. Delhi High Court in case of Sony Ericsson Mobile Communications India Pvt. Ltd. vs. CIT III (ITA No. 16/2014)
For Assessee Appeal
1. The appellant, it is submitted, is engaged in the business of software development and has set up a Business Process Outsourcing (BPO) unit for rendering IT enabled services during the previous year relevant to assessment year 2003-04. The relevant previous year, i.e. previous year 2002-03 was, thus, the first full year of operation of the BPO unit of the appellant. It is submitted that during the previous year 2002-03, the appellant was a start up enterprise, due adjustment ought to be made of the start-up/ one-time costs incurred, which inevitably lead to losses. It is submitted that operating profit/ loss of the appellant for the relevant previous year are required to be adjusted to exclude items of abnormal cost / short fall in revenue (owing to lower rate paid to the appellant as start up) to determine the normal profit that could have been earned by the appellant for the purpose of benchmarking with other companies which are not in start-up stage.
2. In case adjustment of the extra-ordinary expenses and considering the average expenses that would have been incurred in the normal operations, the operating profit margin of the appellant works out to 15%.
3. that the TPO for application of TNMM considered the operating profit margin of the appellant at a loss of Rs.(-) 12,50,09,843 without excluding from the operating results the aforesaid extra ordinary expenses/loss.
4. that for the purpose of benchmarking the international transactions, it is imperative that the effect of such underutilization of capacity/excess fixed costs is eliminated, while computing the operating margins of the appellant.
5. Reliance is placed on following decisions:
a. Mando India Steering Systems Pvt. Ltd. vs. ACIT (ITA No. 2092/Mds/2012)
b. Amdocs Business Services Pvt. Ltd. vs. DCIT (ITA No. 14212/PN/11)
c. Delhi Bench of the Tribunal in the case of Global Turbine Services Inc. vs. ADIT (ITA No. 3484/0e1/2011)
d. Mumbai Bench of the Tribunal in the case of ACIT vs. Fiat India Pvt. Ltd (ITA no 1848/Mum/2009)
e. Hon’ble Pune Bench of the of Tribunal in the case of Brintons Carpers Asia Pvt. Ltd. vs. ACIT ITA. No. 1296/PN/10)
f. the Hon’ble Delhi Bench of the Tribunal in the case of E.I. Dupont India Pvt. Ltd. vs. DCIT (ITA No. 5336/Del/2010),
g. Hon’ble Bangalore bench of the Tribunal in the case of Genisys Integrating Systems (India) Pvt. Ltd vs. DCIT (ITA No 1231/Bang/2010)
h. Hon’ble Delhi’ Bench of the Tribunal in the case of Transwitch India Pvt. Ltd VS. ACIT (I.T.A. No. 6083/Del/2010)
6. In view of the aforesaid, it is respectfully submitted that appropriate adjustment for idle capacity is required to be made while computing the operating margin of the appellant
ITAT decision / observations
1. We have head rival submissions and perused the material on record. Ld. CIT(A) had followed the ratio laid down in the case of Global Ventedge P. Ltd. (supra) (in I.T.A. No. 1432 & 2321 / Del/2009 and 116/Del/2011). This decision was affirmed by both Hon’ble High Court and Hon’ble Supreme Court and his ratio was followed in subsequent decisions as submitted earlier and, therefore, the order of Ld. CIT(A) on this issue is reasonable and we do not find any reason to interfere with this finding of Ld. CIT(A) and hence, the grounds of appeal filed by revenue are dismissed. Accordingly, appeal filed by revenue is dismissed.
2. We have heard rival submissions and perused the material placed on record. We find that there is force in the argument of Ld. Counsel for the assessee that while calculating operating cost, the abnormal cost incurred on account of start-up should be excluded. Following the same parity of reasoning in the cases cited by him and keeping in view that the judgement of ITAT co-ordinate Bench in the case of Transwitch India (supra) affirmed by Hon’ble Delhi High Court. Therefore, respectfully following the decision of Hon’ble High Court, we direct TPO / A.O. to adjust operating cost by excluding abnormal cost incurred on account of start-up company like salary, rent and depreciation. This matter is restored to the file of TPO/A.O. to re-determine the operating cost on the above lines to arrive at operating profit.
Analysed by CA Rahul Sureka
Dear C.A Rahul Surekha
Beautiful article. Please keep writing such articles especially on I.T.P.
With regards
C.A.C.M.A M.Srinivas Kumar