Trilogy E-Business Software India vs. DCIT (ITAT Bangalore)

Transfer Pricing: Comparables cannot be ignored on ground of abnormal profits/losses if they are functionally comparable

The assessee provided software research & development services to its’ USA based AE and was remunerated on a ‘cost plus’ basis. The assessee claimed that applying the TNMM and using operating profits to cost as the Profit Level Indicator (“PLI”), its PLI of 9.98% was at arms length. The TPO & DRP rejected the assessee’s claim and computed the ALP at 24.35% and made an adjustment of Rs. 6.20 crores. The Tribunal had to consider the following issues: (i) whether in selecting a comparable, a turnover filter has to be adopted, (ii) whether companies with abnormal margins can be regarded as comparable, (iii) whether a filter can be applied to distinguish between companies earning revenue from rendering “onsite services” as compared to those rendering “offshore services” even though there is no functional difference between the two activities & (iv) whether the TPO is confined to information in public domain or he can collect information u/s 133(6). HELD by the Tribunal:

(i) S. 92C & Rule 10B(2) clearly lay down the principle that the turnover filter is an important criteria in choosing the comparables because significant differences in size of the companies would impact comparability even there is no functional difference in their activities. Size matters in business because a big company would be in a position to bargain the price and also attract more customers. It would also have a broad base of skilled employees who are able to give better output. A small company may not have these benefits and therefore, the turnover also would come down reducing profit margin. As the assessee’s turnover is Rs. 47 crores, only companies with a turnover between Rs. 1 to Rs. 200 crore should be considered for comparability (Quark Systems 38 SOT 207 (SB), Genesis Integrating Systems & OECD TP Guidelines, 2010, ICAI TP Guidelines followed);

(ii) U/s 92C & Rule 10B(2), there is no bar to considering companies with either abnormal profits or abnormal losses as comparable to the tested party, as long as they are functionally comparable. This issue does not arise in the OECD guidelines and the US TP regulations because they advocate the quartile method for determining ALP under which companies that fall in the extreme quartiles get excluded and only those that fall in the middle quartiles are reckoned for comparability. Cases of either abnormal profits or losses (referred to as outliners) get automatically excluded. However, Indian regulations specifically deviate from OECD guidelines and provide Arithmetic Mean method for determining ALP. In the arithmetic mean method, all companies that are in the sample are considered, without exception and the average of all the companies is considered as the ALP. Hence, while the general rule that companies with abnormal profits should be excluded may be in tune with the OECD guidelines, it is not in tune with Indian TP regulations. However, if there are specific reasons for abnormal profits or losses or other general reasons as to why they should not be regarded as comparables, then they can be excluded for comparability. It is for the Assessee to demonstrate existence of abnormal factors. On facts, as the assessee has not shown any factors for abnormal profits, no comparable can be excluded for that reason (contra view in Quark Systems & Sap Labs noted);

(iii) Though the functions performed by offshore service providers and onsite service providers is the same, i.e. development of computer software, under Rule 10B(2)(b) one has to have regard to the functions performed, taking into account assets employed or to be employed and the risks assumed by the respective parties to the transactions. The “market conditions” are different for on-site and offshore work because in onsite development of computer software, the assessee does not employ assets or assume many risks. Even the per hour rate is different. The fact that in TNMM it is only the margins in an uncontrolled transaction that is tested does not mean that the fact that pricing will have an effect on the margins obtained in a transaction can be ignored. Companies which generate more than 75% of the export revenues from onsite operations outside India are effectively companies working outside India having their own geographical markets, cost of labour etc., and also return commensurate with the economic conditions in those countries. Thus assets and risk profile, pricing as well as prevailing market conditions are different in predominantly onsite companies from predominantly offshore companies like the assessee. Since, the entire operations of the assessee took place offshore i.e. in India; it should be compared with companies with major operations offshore, due to the reason that the economics and profitability of onsite operations are different from that of offshore business model;

(iv) The TPO is entitled to collect information u/s 133(6) though if it is sought to be used against the assessee, it must be furnished to the assessee and his objections taken into account. If the assessee seeks an opportunity to cross examine the party, that opportunity should be provided so that he can rebut the stand of that particular company. On facts, the assessee had not been able to show that the TPO had used information u/s.133(6).