HIGH COURT OF DELHI
Commissioner of Income-tax
versus
Mentor Graphics ( Noida) (P.) Ltd.
BADAR DURREZ AHMED AND R.V.EASWAR, JJ.
IT Appeal No. 1114 of 2008
APRIL 4, 2013
Ms. Suruchii Aggarwal for the Appellant. M.S. Syali, Ms. Husnal Syali and Mayank Nagi for the Respondent.
JUDGMENT
Badar Durrez Ahmed, J.
In this appeal, the revenue has challenged the order of the Income Tax Appellate Tribunal, dated 02.11.2007, passed in ITA No. 1969/Del/2006, relating to the assessment year 2002-03. By virtue of an order dated 13.01.2011, a Division Bench of this court, while admitting the appeal, had framed the following substantial question of law:-
“(i) Whether the finding of the Tribunal that if any one margin of a comparable, in a given set of comparables is lower than the margin of the taxpayer, then the transactions are at arm’s length, is correct in view of the express provisions contained in proviso to Section 92C(2) of the Income-tax Act, 1961?”
2. The counsel for the parties agreed that the above question needs to be re-framed in the following manner:-
“(i) Whether, in view of the first proviso to section 92C(2) of the Income-tax Act, 1961, the Tribunal was correct in holding that if one profit level indicator of a comparable, out of a set of comparables, is lower than the profit level indicator of the taxpayer, then the transactions reported by the taxpayer is at an arm’s length price as contemplated in sections 92, 92C and other related provisions of the said Act?”
3. This question has specifically arisen because of the observation of the Tribunal in paragraph 46.2 of the impugned order which reads as under:-
“46.2 While holding so, we have not adopted mean profit of several comparable found by respective parties because in spite of our repeated requests, the parties before us, were unable to show us any rule or decision under which average or mean margin (OP/TC) of different companies is to be taken. Tax administration and parties can work different Arm’s length price i.e. a range by the application of different methods. In such a situation, mean of Arm’s Length Price as provided in proviso to Section 92C(2) of the Act can be taken. But above Arm’s length range is not the same thing as average operating profits of different entities with different FAR worked through the same method as done in this case by adopting TNMM. The assessee has satisfied not one but several points of arms’s length range worked out on record. In our considered view, it is not necessary for the taxpayer to satisfy all points in the range. Even if one point is satisfied, the assessee can be taken to have established its case and in that situation, the onus is shifted to the department to show why taxpayer’s case be not accepted. Arm’s length price does not mean maximum price or maximum profit in the range. A willing buyer in an open market shall pay minimum and not maximum price for goods or services. Of course, quality and brand name are important but considered not so by T.P.O. as TNMM method was applied by him. Project profile and other factors were, therefore, not erroneously considered. As noted earlier, the case of integrated Hitech has been specifically accepted as comparable by both the parties. On other four cases noted above, the T.P.O. or other revenue authorities have not made any adverse comment at any stage of proceeding. It was open to them in proceedings before the learned CIT(A) or the Appellate Tribunal to show that PIL figure of integrated Hitech or other four companies were wrong or on account of their FAR analysis, these entities could not be taken as “reliable” comparables for computation of the Arm’s Length Price. But no material was brought on record, no arguments advanced to reject the above transaction. Therefore, having regard to facts of the case and material on record, we accept them as comparable and accept the price disclosed by the taxpayer as Arm’s Length Price. Consequently, the addition of Rs. 1,45,73,857 is directed to be deleted. The view taken by us finds support from para 1.4 of OECD guideline which we quote below:-
“1.48 If the relevant conditions of the controlled transactions (e.g. price or margin) are within the arm’s length range, no adjustment should be made. If the relevant conditions of the controlled transaction (e.g. price or margin) fall outside the arm’s length range asserted by the tax administration, the taxpayer should have the opportunity to present arguments that the conditions of the transaction satisfy the arm’s length principle, and that the arm’s length range includes their results. If the taxpayer is unable to establish this fact, the tax administration must determine how to adjust the conditions of the controlled transaction taking into account the arm’s length rante. It could be argued that any point in the range nevertheless satisfies the arm’s length principle.”
4. Insofar as the above observations are concerned, we may straightway refer to the relevant provisions of the Income-tax Act, 1961 (hereinafter referred to as ‘the said Act’). Chapter X deals with special provisions relating to avoidance of tax. Section 92, which is the first section in that chapter, stipulates that any income arising from an international transaction is to be computed having regard to the arm’s length price. “Arm’s length price” is defined in section 92F to mean a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions. It may be pointed out at this juncture that the respondent/assessee is an Indian company which was incorporated in 1998. It is a wholly owned subsidiary of IKOS System Inc., a company incorporated in USA and engaged in the business of software development and also in rendering marketing systems services to the parent company. The present case, as pointed out above relates to the assessment year 2002-03 pertaining to the financial year 2001-02 in respect of which the respondent/assessee filed its return of income on 31.10.2002.
5. The respondent/assessee develops software but does so only upon the instructions of its parent associated enterprise, that is, IKOS Systems Inc. It does not create/develop/sell separate software products or packages and the entire software developed by the respondent/assessee is used by the parent associated enterprise captively for integrating the same with other software components developed by IKOS Systems Inc. The integrated software in turn supports the hardware manufactured by IKOS Systems Inc. and is sold as a separate package in the open market by the latter company. It is, therefore, clear that the respondent/assessee’s business is limited to providing services of software development support entirely to its parent company, that is, IKOS System Inc.
6. From the accounts and the auditors report it appears that the respondent/assessee carried on two sets of transactions with its parent company. One set related to the export of software development services and the other set pertained to the export of marketing support service. In the present appeal we are not concerned with the latter set but are only concerned with the export of software development service, being the international transaction for which the arm’s length price is to be determined.
7. Upon the filing of the return by the respondent/assessee, the assessing officer referred the matter to the Transfer Pricing Officer under section 92CA of the said Act for determination of the arm’s length price. At this juncture it would be relevant to note the provisions of section 92C, to the extent relevant, which reads as under:-
“92C. (1) The arm’s length price in relation to an international transaction [or specified domestic transaction] shall be determined by any of the following methods, being the most appropriate method, having regard to the nature of transaction or class of transaction or class of associated persons or functions performed by such persons or such other relevant factors as the Board may prescribe, namely :-
(a) comparable uncontrolled price method;
(b) resale price method;
(c) cost plus method;
(d) profit split method;
(e) transactional net margin method;
(f) such other method as may be prescribed by the Board.
(2) The most appropriate method referred to in sub-section (1) shall be applied, for determination of arm’s length price, in the manner as may be prescribed:
Provided that where more than one price is determined by the most appropriate method, the arm’s length price shall be taken to be the arithmetical mean of such prices:
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(3) Where during the course of any proceeding for the assessment of income, the Assessing Officer is, on the basis of material or information or document in his possession, of the opinion that-
(a) the price charged or paid in an international transaction [or specified domestic transaction] has not been determined in accordance with sub-sections (1) and (2); or
(b) any information and document relating to an international transaction [or specified domestic transaction] have not been kept and maintained by the assessee in accordance with the provisions contained in sub-section (1) of section 92D and the rules made in this behalf; or
(c) the information or data used in computation of the arm’s length price is not reliable or correct; or
(d) the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by a notice issued under sub-section (3) of section 92D,
the Assessing Officer may proceed to determine the arm’s length price in relation to the said international transaction [or specified domestic transaction] in accordance with sub-sections (1) and (2), on the basis of such material or information or document available with him:
Provided that an opportunity shall be given by the Assessing Officer by serving a notice calling upon the assessee to show cause, on a date and time to be specified in the notice, why the arm’s length price should not be so determined on the basis of material or information or document in the possession of the Assessing Officer.”
In view of the above provisions, it is apparent that the arm’s length price in relation to an international transaction has to be determined by following one of the methods prescribed in sub-section (1) of section 92C. In the present case there is no dispute that it is the transactional net margin method (TNMM) which is the most appropriate method and which had been adopted both by the respondent/assessee as well as by the Transfer Pricing Officer. The proviso to sub-section (2) of section 92C makes it clear that where more than one price is determined by employing the most appropriate method, the arm’s length price shall be taken to be the arithmetical mean of such prices. There is no dispute that the prices which are to be considered while computing the arithmetical mean as indicated in the said proviso are all prices determined by following any one of the methods stipulated in section 92C(1). It does not have any reference to prices being determined by more than one method. This is so because the reference is to the price determined by the most appropriate method and that can be only one method. We have already indicated above that in the present case the most appropriate method, as accepted both by the respondent/assessee and by the revenue, was the transactional net margin method. The dispute that has arisen in the present case is with regard to the observation of the Tribunal to the effect that where one of the prices determined by the most appropriate method is less than the price as indicated by the respondent/assessee, that may be selected and there would be no need to adopt the process of taking the arithmetical mean of all the prices arrived at through the employment of the most appropriate method. That observation of the Tribunal, we may say straightway, is incorrect. When more prices than one are thrown up by the most appropriate method, the statute requires that the arm’s length price shall be taken to be the arithmetical mean of such prices. This is the plain and simple meaning of the proviso to section 92C(2) of the said Act.
8. Having said so, we may now notice the provisions of sub-section (3) of section 92C which we have already extracted above. A reading of the said provision makes it clear that if the assessing officer in the course of any proceeding of assessment, on the basis of material or information or documents in his possession, is of the opinion that any of the 4 conditions (a) to (d) stipulated in sub-section (3) are satisfied then, the assessing officer may proceed to determine the arm’s length price in relation to the international transaction in accordance with the provisions of sub-section (1) and sub-section (2) of section 92C on the basis of such material or information or documents available with him. Provided, of course, that an opportunity is given by the assessing officer to the assessee to show cause as to why the arm’s length price should not be so determined on the basis of material or information or document in the possession of the assessing officer. In other words, in the aforesaid circumstances the assessing officer may himself embark upon the determination of the arm’s length price. However, where the assessing officer considers it necessary to do so, he may with the previous approval of the commissioner, refer the computation of the arm’s length price to the Transfer Pricing Officer. This is provided in section 92CA of the said Act which, to the extent relevant, reads as under:-
“92CA. (1) Where any person, being the assessee, has entered into an international transaction [or specified domestic transaction] in any previous year, and the Assessing Officer considers it necessary or expedient so to do, he may, with the previous approval of the Commissioner, refer the computation of the arm’s length price in relation to the said international transaction [or specified domestic transaction] under section 92C to the Transfer Pricing Officer.
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(3) On the date specified in the notice under sub-section (2), or as soon thereafter as may be, after hearing such evidence as the assessee may produce, including any information or documents referred to in sub-section (3) of section 92D and after considering such evidence as the Transfer Pricing Officer may require on any specified points and after taking into account all relevant materials which he has gathered, the Transfer Pricing Officer shall, by order in writing, determine the arm’s length price in relation to the international transaction [or specified domestic transaction] in accordance with sub-section (3) of section 92C and send a copy of his order to the Assessing Officer and to the assessee.”
9. Coming back to the facts of the present case, the assessing officer while considering the assessment of income of the respondent/assessee had, in terms of section 92CA(1) of the said Act referred the computation of arm’s length price to the Transfer Pricing Officer. That being the position, it is clear that the Transfer Pricing Officer, in view of the provisions of section 92CA(3), was also required to follow the same methodology and approach as was incumbent upon the assessing officer under section 92C(3) of the said Act. In other words, the Transfer Pricing Officer would have to, first, form an opinion that any of the four conditions (a) to (d) set out in sub-section (3) of section 92C existed and then he could proceed to determine the arm’s length price in relation to the international transactions in question in accordance with sub-sections (1) and (2) of section 92C on the basis of such material or information or document available with him. After the Transfer Pricing Officer determines the arm’s length price, it is incumbent upon him to send a copy of the order to the assessing officer and to the assessee. In the present case what has happened is that the Transfer Pricing Officer has generally rejected the comparables submitted by the respondent/assessee in his transfer pricing report and has rejected the suggested arm’s length price based on a profit level indicator of 6.99% as determined by the respondent/assessee and, in place thereof, the Transfer Pricing Officer adopted a profit level indicator of 24.53% and determined the arm’s length price of the international transactions at Rs. 10,34,40,177/- as against Rs.. 8,88,66,320/- returned by the respondent/assessee. This resulted in an adjustment of Rs. 1,45,73,857/- in the income of the assessee being the difference between the arm’s length price and the price charged by the assessee from its associated enterprise (IKOS System Inc.) for rendering services to them. Thereafter, the assessing officer passed the assessment order on 28.03.2005, inter alia, after making the aforesaid addition. We are not concerned with the other aspects of the assessment order.
10. The CIT (Appeals) confirmed the said addition by virtue of an order dated 30.03.2006. Being aggrieved by the said order, the respondent/assessee preferred an appeal before the Income Tax Appellate Tribunal which has been allowed by the said Tribunal. The revenue is in appeal before us. While allowing the respondent/assessee’s appeal, the Tribunal made the observations in paragraph 46.2, which we have already extracted above, to which serious exception was taken by the revenue. We have already indicated that the question that has been framed, has to be decided in favour of the revenue and against the respondent/assessee. But, the matter does not end there inasmuch as we have to also examine as to what is the effect of such an answer.
11. It may be pointed out that the Transfer Pricing Officer had rejected the comparables submitted by the respondent/assessee. However, that rejection was of all comparables, generally. None of the 16 comparables submitted by the respondent/assessee were specifically rejected. The manner in which the comparables were rejected is indicated in Para 7.2 of the Transfer Pricing Officer’s order, which reads as under:-
“7.2 An analysis of the comparables used by the assessee and the search criteria used by it was carried out and it was observed that:
♦ The assessee has not eliminated the companies which are not comparable in terms of their size i.e. their turnover. It has included all the companies without giving any consideration to the fact that certain comparable companies are new in the business and their profits are more likely to be low in initial years.
♦ The assessee has not used the data for the year 2002, which is not in line with the provisions of Transfer pricing.
♦ The assessee has rejected certain companies stating that they have different product profile, which cannot be considered as valid reason since while adopting TNMM, the base has to be a larger one so as to eliminate various functional differences. Further, had the product profile to be matched, then even all those comparables which were finally selected should not have been there since none of them is into development of chip design software, which is the main business of the assessee.
♦ Companies having high ratio of trading, activity were not excluded.”
12. It may be clarified that while six companies have been specifically mentioned in the Transfer Pricing Officer’s order, there is no such specific elimination in respect of the other ten comparables. Insofar as the aforesaid six comparable companies are concerned, the observations of the Transfer Pricing Officer were as under:-
“7.5 On 20.01.2005 the assessee was again asked to explain as to why the companies having substantially low turnover as compared to that of the assessee, companies engaged primarily in manufacturing activity and companies with low employee cost (as software development companies typically have high wages/salaries to total sales ratio), may not be eliminated. The list of such companies is as under :
