Transfer Pricing – If loss making companies were excluded, a super profit earning company should also be removed from the comparables

IN THE INCOME TAX APPELLATE TRIBUNAL
DELHI BENCH “E” NEW DELHI
BEFORE SHRI RAJPAL YADAV, JUDICIAL MEMBER
AND
SHRI SHAMIMYAHYA, ACCOUNTANT MEMBER
I.T.A. No. 5263/Del/2010

A.Y.: 2006- 07

ORDER

2. The first issue raised is that Assessing Officer has erred in making addition of 14,79,00,000/- on account alleged difference in arms’ length price of the international transactions of software development services on the basis of the order passed u/s 92CA(3) of the Act by the Transfer Pricing Officer.

3.The assessee in this case is a subsidiary of M/s Sapient Corporation, USA. The company was incorporated on March, 9, 2000 and was set up under the Software Technology Park Scheme of the Government of India. The assessee renders customized software development services to associated enterprises and also renders post sales support services. The assessee in the relevant assessment previous year has entered into international transactions with associated enterprises. In the Transfer Pricing documentation the assessee determined the arms’ length price of the international transactions of software development and related services by applying TNMM as most appropriate method. The assessee had benchmarked its international transactions with 10 comparable companies with an average operating profit ratio (OPtTC) of 9.3 1%.

3.1 The final list of comparable companies is as under:–

The operating profit margin (OPIOC) of the assessee was computed at 12.49%.

Since the (OPtTC) earned by the assessee on transactions with the associated enterprise at 12.49% was higher than the average operating profit margin earned on similar transactions with unrelated third parties at 9.31% the international transaction of provision of software design and development services was considered to be at arms’ length price.

The TPO in the course of the Transfer Pricing assessment proceedings required the assessee to submit current year data of all comparable companies considered in transfer pricing study report. Since at that time, financials of Datamatics Limited was not available, the appellant submitted current year operating results of the remaining 9 companies with an OPtTC ratio of 12.05% as follows:-

Accordingly, the Transfer Pricing Officer in the order passed under section 92CA(3) of the Act computed an adjustment of 14,79,00,000/- on account of the difference in the margin of the comparable companies and the appellant company.

4. Against the above order, the assessee is in appeal before us.

5. Assessee’s submissions in this regard are summarized as under:-

“(i) The TPO has considered Zenith Infotech even though when it earning supernormal profits and does not satisfy his own additional filters:

Zenith Infotech has remarked an abnormal high profit margin of 49.73% during the financial year 2005-06 and there has been sharp increase in profitability and sales. The OPtTC during the year is summarized as follows:-

It may be pointed out that Zenith Info tech is pre-dominantly software product company, while the appellant is engaged in rendering software development services. It is a matter of common knowledge that a software product company ends up earning higher margin as they are engaged in selling software products owned by them. The aforesaid is also corroborated from the facts that wages to cost ratio of Zenith Infotech is only 37.5% (which is usual case in the case of software product company) as opposed to 65% in the case of the appellant a

software service company. (refer page 852-855 of the supplementary paper book for brief product profile of Zenith taken from the website www.zenithinfotech.com)

The DRP rejected the contention of the appellant of excluding the above company from the set of comparable companies on the ground that the said company was included in the list of comparable companies in the transfer pricing report.

Reliance in this regard is placed on the ruling of the Hon’ble Chandigarh ITA T, [Special Bench in the case of Quark Systems Private Limited v. DCIT: 2010 38 SOT 307 while reviewing the comparability analysis of super profit compal1les provides as under:

” Even if the taxpayer or its counsel had taken Datamatics as comparable in its IP audit, the taxpayer is entitled to point out to the Tribunal that above enterprise has wrongly been taken as comparable. In fact there are vast differences between tested party and Datamatics. The case of Datamatics is like that of Imercius Technologies” representing extreme positions. If Imercious Technologies has suffered heavy losses and, therefore, it is not treated as a comparable by the tax authorities, they also have to consider that Datamatics has earned extraordinary profit and has a huge turnover.” (emphasis supplied)

Reliance in this regard is also placed on the following decisions wherein a super profit margin company has been directed to be excluded:

Adobe Systems India (P) Ltd. v. ACIT: LT.A. No. 5043/De1/2010 Mentor Graphics (Noida) Pvt. Ltd : 109 ITD 101

E-Gain Communication Pvt. Ltd. v. DCIT: 118 ITD 243

Philips Software Centre (P) Ltd. v. ACIT: 119TTJ721

ITO v. Sunay Jewels Pvt. Ltd: ITA No. 5758/Mum/2007

Further, Zenith Info tech cannot be taken as comparable also for the reason that, (i) the wages to cost ratio of Zenith Info tech is 37.50% as against the wage to cost ratio of the applicant at 65% and (ii) Forex earning of said company is _only 39% of the total revenue. It may be noted that the TPO has himself had rejected Melstar Information Technologies, inter alia, on the basis of low Forex earnings without applying the same selection criteria while considering Zenith Info tech Ltd. as comparable company.

Computation of margin of comparable after eliminating Zenith Info tech

The average of operating profit over cost of the  remaining three companies after eliminating Zenith Infotech Software is as follows:

Since the OPtTC of the appellant at 12.49% is within the safe harbor range of (+I-)5% as per the proviso to section 92C(2) of OPtTC margin of 3 comparable companies at 13.01%, no adjustment is warranted on account of difference in arm’s length price of the international transaction.

(ii) Rejection on the basis of additional filters

In addition to the filter of wages/cost ratio, the TPO in his order has applied the following additional filters:

a. Forex earning

b. Declining operating results and sales c. Negative net worth

It is submitted that that the additional filters have been used by the TPO to suit his requirement and to arrive at predetermined results. It would be appreciated that rejection of the companies on the basis of the profit margin, rather than functional or asset profile, would not meet the comparability standard required in application of the “TNMM’ method, which is selected by the appellant as the most appropriate method for benchmarking. It is a settled position that under the transfer pricing regulation, the comparability is to be judged with reference to functions performed, assets utilized and risk assumed (FAR) and the aforesaid functions parameters such as declining operating results and sales, etc., are not the relevant consideration.

Reliance in this regard is placed on the following decisions:

a. Mentor Graphics (Noida) Private Limited: 109 ITD 101

b. E-Gain Communication Pvt. Ltd. 118 ITD 234

c. Aztec Software India Pvt. Limited: 107 ITD 141

d. Sony India Pvt. Limited: 114 ITD 448

e. Philips Software: 26 SOT 226

f.  Quark Systems Pvt. Limited v. DCIT: ITA NO.1 00 & 115/CHD/2009 g. DCIT vs Indo American Jewellery Ltd.: 131 TTJ 163″‘

6. Alternatively the assessee had made fresh data base to identify comparables companies. According to which the average PLI is 12.60%. Assessee has claimed that since the operating profit ratio of the assessee at 12.49% is within the safe harbor of (+/-) 5% provided in section 92(2) of the Act with respect to the average of operating profit margin of the above comparable companies, i.e. 12.49%, the international transaction entered into by the assessee with associated enterprises, are, therefore, considered being at arms length price on the applying TNMM. The DRP however, did not deal with the aforesaid fresh set of comparable placed on record by the assessee.

7. Ld. Departmental Representative on the other hand has submitted that Zenith Infotech was chosen by assessee itself in the list of comparables. Hence, the assessee cannot agitate against its inclusion. The Ld. Departmental Representative further claimed that assessee has raised perfunctory objection before the authorities below regarding exclusion of Zenith Infotech in the comparable. Hence the matter was not dealt with in detail by the TPO or the DRP. In the rejoinder, ld. counsel of the assessee has submitted that all the necessary documentation in this regard were before the TPO and the DRP. Ld. counsel of the claimed that if loss making companies were taken out by the TPO from the comparables, Zenith Infotech Ltd. which had shown super normal profits should also be excluded. Ld. counsel of the assessee further claimed that there is no estoppels against the assessee. Now assessee has claimed that Zenith Infotech is not comparable. Ld. counsel further claimed that there cannot be any motive to the assessee as the entire income is exempt u/s 1OA.

8. We have heard the rival contentions in light of the material produced and precedents relied upon. We find that TPO in his order has rejected the five comparable companies identified by the assessee. the TPO bench marked the operating profit margin by the assessee company with four profit making companies, which excluded Zenith Info tech Ltd. The margin of these companies are as under:-‘

8.1 Now it is the contention of the assessee that when loss making companies were taken out from the com parables by the TPO, the super profit earning company, Zenith Info tech Ltd. should also be removed from the com parables. Ld. counsel of the assessee further claimed that this company does not satisfy TPO’s own additional filters. It has been submitted that Zenith Info tech Ltd. has shown abnormal high profit margin. It has been submitted that Zenith Info tech Ltd. Is predominantly software product company, while the assessee is engaged in rendering software development services. It has been submitted that software product company ends up earning higher margin as they are engaged in the selling of software products owned by them. Upon careful consideration, we find ourselves in agreement with the assessee’s contention that when the loss making companies have been taken out from the list of com parables by the TPO, Zenith Info tech Ltd. which showed super profits should also be excluded. The fact that assessee has himself included in the list of com parables, initially cannot act of estoppel particularly in light of the fact that Assessing Officer has only chosen the companies which are showing profits and has rejected the other companies which showed loss. In this regard reliance can be placed upon ITAT Special Bench decision in the case of Quark System vs. DCIT (2010) 38 SOT 307, which supports assessee contention of removal of Zenith Infotech from comparables, as it showed super profits. Furthermore, it is noted that Zenith Info tech is predominately software product company, while the assessee is engaged in rendering software development services. It is found that software product company shows higher margin. This is also     corroborated by the fact that wages to cost   ratio of Zenith Info tech is only 37.5% as opposed to 65% of assessee company. Hence, we are    of the considered opinion that when loss making companies have been removed from com parables by the TPO, assessee is right in contending that Zenith Info tech should also be removed as it showed super profits. As submitted in the chart in preceding paragraph the average of operating profit over cost of the remaining three companies after eliminating Zenith Infotech Software is as follows:

Since the OP/TC of the appellant at 12.49% is within the safe harbor range of (+/-)5% as per the proviso to section 92C(2) of OP/TC margin of 3 comparable companies at 13.01%, no adjustment is warranted on account of difference in arm’s length price of the international transaction.

8.2 The contention of the Ld. Departmental Representative that assessee has not vigorously agitated the issue of inclusion of Zenith Info tech before the authorities below is not acceptable, as all the necessary documents for assessee’s contention in this regard were before the authorities below.

8.3 In the background of the aforesaid discussion, we delete the addition made by the Assessing Officer with regard to arms’ length price.

9. The next issue raised is that Assessing Officer has erred in making disallowance of 1,18,31,549/- out of expenditure on advertisement and sale promotion and recruitment and training expenses. aggregating to 1,57,75,411/- holding that such expenses were incurred for better sales and turnover and contribution to the profits of the business and hence benefit of which expenditure accrued to the assessee over the years.

10. On this issue the Assessing Officer noted that as per the profit and loss account the assessee company has claimed expenditure of 1,29,25,617/- on account of recruitment and training expenditure and 28,49,794/- on account of advertisement and sales promotion expenses.

11. Assessing Officer was of the opinion that these expenditures has given the assessee benefit spread over a certain number of years. In this regard, assessee has contended that Income Tax Law does not provide ‘concept of deferred revenue expenditure’. Assessing Officer did not accept this proposition and he held that the above said expenditure leads to an enduring benefit to the assessee company. Accordingly, only 25% of the expenditure of 39,43,852/- was allowed and the balance amount of 1,18,31,559/- was disallowed and added to the total income of the assessee company.

12. Against the above order the assessee is in appeal before us.

13. Assessee has submitted that the aforesaid expenditures are incurred on revenue account and did not result in any enduring benefit in the capital field. Further, there is no concept of deferred revenue expenditure under the Income Tax Act and expenses are to be allowed deduction in full in the order in which they are incurred. In this regard, assessee placed reliance of catena of case laws. It has further been submitted that the Ld. Commissioner of Income Tax (Appeals) in assessee case for A.Y. 04-05 vide order dated 8.11.2007, deleted the similar disallowance made by the Assessing Officer in that year. It has been claimed that department has accepted the findings of the Ld. Commissioner of Income Tax (Appeals) with respect to dis allowance of recruitment and training expenses and advertisement expenses and did not appeal to the Tribunal on this account.

14. Ld. Departmental Representative relied upon the orders of the Assessing Officer.

15. We have heard the rival contentions in light of the material produced and precedents relied upon. We find that it is not the case here that the expenses are bogus and not incurred. It has also not the case that the entire expenses falls under the realm of capital expenses. The Assessing Officer is of the opinion that only 25% of the expenditure should be allowed during the year and the rest has to be added to the income of the assessee. We find ourselves in agreement with the contention of the ld. counsel of the assessee that there is no concept of deferred revenue expenditure under the IT law. The expenditure of account of recruitment and training expenses and advertisement and sales promotion expenses cannot be said to be capital expenditure. Under these circumstances, Assessing Officer’s action in this regard is not sustainable. Moreover, we note that similar dis allowance were deleted by the Ld. Commissioner of Income Tax (Appeals) in the assessment year 2004-05 against which the department did not file appeal before the Tribunal.