Chandigarh Tribunal (Special Bench) ruling in the case of DCIT Vs. M/s Quark Systems Pvt. Ltd. (ITA No. 100/Chd/2009) and M/s Quark Systems Pvt. Ltd. Vs. ITO, Ward 5(4) (ITA No. 115/Chd/2009) re-states the ‘importance’ of FAR analysis and provides useful guidance on some of the basic parameters which needs to be considered for selecting ‘appropriate’ com parables.

Facts of the Case

  • Quark Systems Pvt. Ltd. (Quark/ Taxpayer), a wholly owned subsidiary of Quark Systems SARL (AE), is a captive unit which provides technical and advisory services to its AE’s clients.
  • During the audit proceedings, the transfer pricing officer (TPO) rejected one of the comparable companies ~ Imercius Technologies Pvt. Ltd. (Imercius) on the following grounds:

-it is a continuous loss-making company;

– its turnover [INR 1.45 crores] is not comparable to that of Quark’s turnover [INR 13.6 crores]; and

-it is a start-up company having negative net worth as on March 31, 2004.

Accordingly, TPO made an upward adjustment to Quark’s international transaction.

  • Subsequently, the CIT(A) upheld the TPO’s exclusion of Imercius on the following additional rationales:

-being a start-up company, it has large setting-up expenses and low turnover;

?  Transition and customer contact services provided by Imercius are not comparable to the services provided by Quark; and

-it’s personnel expenses are unusually high [INR 2.17 crores] as compared to its turnover [INR 1.45 crores].

  • However, the CIT(A) granted partial relief in Quark’s favor by allowing the benefit of +/-5 per cent.

Aggrieved by the decision of the CIT(A), Quark and the department filed cross appeals with the Tribunal against the order of the CIT(A).

Issues, Contentions and the Tribunal’s Ruling & Observations

Issue 1:

  • Whether exclusion of Imercius is justified?

Taxpayer’s Contention:

  • The Taxpayer invited the Tribunal’s attention to the fact that two other loss-making companies were also considered as com parables. Further, the Taxpayer argued that the findings of the subordinate authorities on Imercius are flawed on the following basis:

-The year of operation has no affect on comparability and there are no start-up expenses evident in Imercius financials.

-It had positive net worth at the start of the relevant year which turned negative at the year end due to losses incurred during the year. Further, Imercius’ promoter company had funded it by way of an unsecured loan which may be considered as ‘quasi’ capital.

-Differences in turnover do not impair comparability.

  • In addition, during the course of the hearing, the Tribunal probed on the following:

-Screening of com parables on the basis of asset base:

-Incorrect application of turnover filter (i.e. it is open ended).

-Screening based on employee cost to sales ratio.

  • The Taxpayer also emphasized on the need to make adjustments on account of differences in the risk profile.

Tribunal’s Ruling:

  • The Tribunal has observed that the basic functional analysis has not been conducted. Telemarketing services performed by Imercius are inherently different in nature and scope vis-à-vis the services performed by Quark. Just because Quark and Imercius are grouped under the same head in Prowess database comparability can not be established. Further, the risk analysis also demonstrates the difference between Imercius and Quark.
  • Imercius with negative net worth cannot be treated at par with a normal business organization.
  • The Tribunal held that the application of a turnover filter for rejecting companies having a turnover of less than INR 1 crore is without any rationale basis. Further, applying no filter to reject companies with high turnover is an inappropriate approach.
  • While the Tribunal agreed that merely because a comparable is making loss, it cannot be excluded. However, Imercius is incomparable to Quark due to various reasons cited above. Thus, the Tribunal has upheld CIT(A)’s order and rejected Quark’s plea.

Issue 2:

  • Reject Datamatics Technologies Ltd. (Datamatics)? (raised by Quark through an additional ground before the Tribunal. 2 However, the Revenue had vehemently opposed the admission of the said ground as it would have led to a fresh TP analysis.

 Taxpayer’s Contention:

  • The Taxpayer contended that consistent with the stand to reject Imercius, the Revenue should have rejected a high-margin company like Datamatics.
  • Although Datamatics was originally selected as a comparable company by the Taxpayer, the fact that it has significant related party transactions and inadvertent calculation errors has vitiated the transfer pricing (TP) analysis. Further, the Taxpayer also contended that as the CIT(A) had the relevant financial information, he should have taken the correct position.
  • Based on the afore-said, the Taxpayer had claimed to reject Datamatics.

Tribunal’s Ruling:

  • In this regard, the Tribunal has made the following observations:

-On a prima facie basis, Datamatics is not a comparable entity as it has earned extraordinary profit and has a huge turnover in which case it represents an extreme position just like Imercius. Further, there are differences in assets and other characteristics also.

-Further, the Tribunal has relied on various case laws and OECD TP Guidelines 2009 to hold that merely because Quark itself has selected Datamatics as a comparable company; it is not estopped from pointing out a mistake in the assessment. In addition, with a Tribunal being a fact-finding body, it has to take into account all the relevant material and determine the question as per the statutory regulations.

Considering these factors, the Tribunal concluded that since this ground was first raised only before the Tribunal and not before the Tax Authority, the matter be remitted to the AO for consideration. While so remanding, it allowed Quark to submit all the relevant evidence before the AO and fully cooperate in expeditious disposal of the matter in accordance with the law.

  • The Tribunal also noted that as the TP regulations were relatively new, such a lenient approach has been adopted in order to give an opportunity to the Taxpayer to ensure that the Taxpayer is not at a disadvantage and the correct arm’s length is ascertained.

Issue 3:

Allow ability of +/- 5 per cent benefit?

Tribunal’s Ruling:

The Tribunal held that this matter needs to be adjudicated in light of the recent amendment made to the proviso to Section 92(C)(2) Which is effective from October 1, 2009 of the Income-tax Act as the wordings of the amended proviso are significantly different in scope and application vis-à-vis those of the pre-amended proviso. Accordingly, the Tribunal has remanded the matter to the file of the AO for adjudication ‘de novo

 Additional Observation:

The basis of selection of comparable companies and application of filters is inappropriate and open ended.

Our Comments

This Tribunal ruling is once again a step in the right direction, as it refocuses and re-emphasizes on some of the basic fundamentals of TP as summarized below:

  • The ruling again lays stress on the ‘critical importance’ of conducting comprehensive functional profile (i.e. review of the functions performed, asset used and risk assumed) of the tested party as well as the comparable companies which should inter-alia include detailed analysis of the factors! parameters that affect the basis of pricing! business model of an organization.
  • Another key proposition re-affirmed by the Tribunal is the acceptance of loss-making companies after detailed analysis, on the ground that they are reflective of the market conditions.As in the case of Mentor Graphics (Noida) Pvt. Ltd. Vs. DCIT (ITA NO. 1969/D/2006) and Sony India Private Limited vs. DCIT (I.T.A.Nos.1189/Del/2005, 819/Del/2007 & 820/Del/2007)
  • Further, the decision also reinforces the importance of applying proper filters which are based on ‘cogent reasoning’ and not on unsound presumptions (As in the case of Mentor Graphics (Noida) Pvt. Ltd. vs. DCIT (supra)).
  • Queries raised by the Tribunal clearly provide insight into the increased inclination of the authorities to apply ‘stringent’ parameters for determining comparability.

Further, with TP being a fact-based exercise, an important decision taken by the Tribunal of allowing the Taxpayer to retract from its earlier position due to additional factual findings at the time of audit proceedings would provide relief to a lot of Taxpayers. However, it is pertinent to note that the Tribunal has simultaneously made an observation that it has taken such a liberal approach on this matter as TP was in its ‘nascent’ stage during the relevant tax year. Therefore, as the TP practice will mature in India such a window of lenient view may not be available to the Taxpayers and hence, it would be imperative to conduct a detailed and a comprehensive analysis.


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September 2021