TII Instant Update - 2017-TII-INSTANT-ALL-490

TII BRIEF

CASE LAWS

2017-TII-350-ITAT-DEL-TP

CADENCE DESIGN SYSTEMS INDIA PVT LTD Vs DCIT: DELHI ITAT (Dated: September 4, 2017)

Income Tax - Sections 92C(2) & (3), 143(3), 144C

Keywords : Arm's Length Price - Cherry picking - Comparable company - Estoppel - FAR - TP Study Report.

The Assessee-company is a wholly owned subsidiary of (CDS) and provides R&D and IT services from its unit located in Special Economic Zone. Assessee is mainly a captive service provider and risk mitigated entity, which is compensated on a cost plus mark up basis for the services rendered to its AE's. So far as software research development services were concerned, the Assessee was compensated with cost plus mark up of 15% and actual PLI was arrived at 15.07%. The Assessee had entered into an agreement with CDS for providing research and software development services to CDS utilizing groups' R&D technology and other appropriate technology. Assessee's business risk exposure was limited, as it provides software development services only to CDS and was assured of specific return on its cost.

Based on FAR analysis, the Assessee carried comparability analysis by adopting TNMM as most appropriate method with PLI (OP/OC) arrived at 15.07%, considering depreciation on palladium machine as non-operating and foreign exchange fluctuation as operating expenditure. In its TPSR the Assessee had shortlisted 21 companies' with weighted average OP/OC at 14.35%. Hence it was reported that its margin was at ALP. However, the TPO after detailed analysis, modified the set of comparables and arrived at set of 14 comparable companies. On reference, the DRP also confirmed the said comparables as shortlisted by the TPO and only granted working capital adjustment, and finally the average profit margins of comparables was worked out to 23.45%. The Assessee out of that 14 comparables sought for exclusion of three comparables viz. (i) Bodhtree Consulting Limited; (ii) Infosys Technologies Limited; and (iii) Sonata Software Limited and inclusion of one comparable viz. (i) Gold Stone Technologies.

On the issue of Transfer Pricing Adjustment on provision of IT back office support service (ITS) segment, the facts was that the Assessee had rendered services on cost plus margin of 15%. The assessee had entered into an agreement with CDS, pursuant to which the Assessee was responsible for providing CDS and other Cadence affiliated entities, IT back office support services which comprise of UNIX/Windows administration & support; Internal helpdesk services; Application development & support; Web development & support; and Customer support. In that segment also the Assessee was risk mitigated entity and was was compensated for services rendered with a fee which is equal to operating expenses incurred plus an amount equal to 15% of operating expenses and the payment terms laid down that the assessee would invoice CDS for its services on periodic basis and CDS was required to pay invoice amount within 90 days on receipt of invoice. In its transfer pricing study report, the assessee adopted TNMM as MAM with PLI as OP/OC. After carrying out detailed analysis, the assessee shortlisted 7 comparable companies with weighted average operating profit margin arrived at 19.41% and taking cue of tolerance range of +/- 5% it was submitted that its margin met the arm's length requirement.

The TPO however modified the set of comparables and finally adopted 8 comparable companies within average arithmetic mean of 71.11%. On reference the DRP had excluded one Genesys International Limited and finally 7 sets of comparables were left. Out of those 7 comparable companies, assessee had challenged exclusion of 4 companies namely, (i) Accentia Technologies Ltd.; (ii) Cosmic Global Ltd.; (iii) Eclerx Services Ltd.; and (iv) Vishal Info Tech. Apart from that, assessee from his own set of comparables had sought inclusion of 4 comparable companies namely, (i) CG VAK Software and Exports Ltd. (segmental); (ii) R Systems International Limited (segmental); (iii) Micro Land; and (iv) Microgenetics Systems Limited.

On the issue of adjustment on account of interest on outstanding receivables, the TPO has made TP adjustment for overdue receivables and pre and post sales agreement by applying the interest rate of 15.77% after taking the PLR rate of State Bank of India, which was around 12 to 13.75% during the financial year 2008-09. After adding 300 basis points, he considered interest rate of 15.77% as arm's length level of interest, i.e., should have been charged on the outstanding receivables from the AE. Accordingly, he made adjustment of Rs.18,53,109/-.

On appeal, the Tribunal held that,

Whether when Bodhtree is a global IT consulting and product engineering service provider, it can still be held to be comparable with the assessee, which is a purely R&D captive service provider - NO: ITAT

+ the assessee under the provision of software research and development services carries out R&D services for its AE for the development of software products to its CDS utilizing R&D technology of CDS only. CDS specifies R&D services to be performed; products to be developed or used; timeline for completion and specific result to be achieved. The entire conceptualizing of the marketing strategy for sales of its products and services, securing of orders of its products are done by CDS and not by the assessee. The assessee company is purely a ‘captive service provider' and does not undertake any kind of marketing or development functions. Conceptualization of services and determination of exact scope of work, which is to be performed by the assessee, is responsibility of CDS. Even the quality control, testing of the products is all done by CDS. Now, on analyzing the functions of the assessee, which is purely R&D being a captive unit vis-à-vis the functions of Bodhtree, it is found that this company is into IT consulting and product engineering service and has a wide array of business activities like data warehousing and data management. It has only one segment namely, software development and being a software solution company, it is engaged in providing open and end-to-end web solutions, off shores data management and data consultancy design and development solution. Such functions, though may be said to be carried out by the AE i.e. Cadence, but it cannot be said that similar functions have been performed by the assessee. Even on the risk analysis, the comparability fails as assessee is purely risk mitigated company as discussed above. There are catena of decisions of various Benches of the Tribunal like in case of Cisco Systems India Pvt. Ltd. vs. DCIT 2014-TII-186-ITAT-BANG-TP, wherein it was held that this company is rendering software business of developing software products and is providing open and end-to-end web solution, software consultancy and design and development of software and the same cannot be held to be comparable with the companies, which are purely into software development services and not into software products. Apart from that, in the case of Fiserv India (P.) Ltd., this comparable has been excluded after considering various decisions of the Tribunal. Coming to the arguments of the Revenue that during the course of search analysis, the assessee too has chosen the companies by adopting search criteria of company into ‘software products' and therefore, the assessee now is precluded from making a distinction that software product companies should be excluded. Such a contention of the Revenue cannot be accepted, because selection of comparables by using any search criteria is one of the process of shortlisting the companies by applying various quantitative and qualitative filters in the wide array of companies in the data. Once in the search process, certain companies are thrown in the search result, then it is incumbent that deep FAR analysis is to be done so as to carry out proper comparability analysis with the tested party so as to benchmark and arrive at a proper Arm's Length Price. If at the functional level, it is shown that functions performed by the assessee is entirely different from the functions carried out by the comparable companies, or it does found comparable either under risk analysis or assets deployed, then such comparable companies should not be excluded from comparability analysis. Accordingly, Bodhtree cannot be included as comparable for benchmarking the assessee's margin.

Whether when Infosys Technologies Limited is a giant enterprise with huge turnover, it cannot be compared with the assessee as the comparability analysis fails on all the factors of FAR - YES: ITAT

+ Infosys Technologies Limited is a giant enterprise with turnover of more than Rs.20,264 crores. Its expenditure on R&D was Rs. 267 crores and it has huge brand value and significant intangible assets, which have been valued at approximately Rs.1,34,478 crores. If these assets are to be compared with those of the assessee, it can be seen that it has ‘nil' expenditure on R&D and no significant intangible asset. On this ground alone, various Benches of the Tribunal have held that Infosys Technologies Limited cannot be compared with small software companies, who are into contract software development services. A company like Infosys with mega operations and having significant assets and brand value and full-fledged risk taking entrepreneur developing and selling proprietary products cannot be held to be comparable with the captive service and contract software development companies as the comparability analysis fails on all the factors of FAR. The Delhi High Court in the case of CIT vs. Agnity India technologies Pvt. Ltd. made a comparative chart while dealing with similar comparative analysis and respectfully following the same, it was hold that Infosys Technologies Limited cannot be compared with the assessee-company, which is operating at minimal risk and is a contract software development service provider;

+ the assessee as well as the authorities below, have disputed the percentage of related party transactions. In order to ascertain the exact related party transactions, we are of the opinion that this matter should be restored back to the file of TPO, who shall examine the exact RPT, because at the face of its annual accounts it is seen that Sonata Software Limited has related parties and service charges credited to the profit & loss account. The related party transactions to the sales ratio needs to be examined and if the RPT filter applied by the TPO as well as DRP fails the benchmark of 25%, then this comparable should not be included for comparative analysis. If RPT ratio is less than filter of 25%, then this comparable needs to be properly analysed under FAR analysis. The TPO will give opportunity to the assessee to substantiate its claim about ratio of RPT transactions and if required then in FAR comparability. On the matter of Gold Stone Technologies, order of the DRP is to be set aside on this comparable and restore the matter to the file of the TPO to see, whether segmental information are available or not and if the same are available, then said company should be included after carrying out proper comparable analysis. The TPO shall provide due opportunity to the assessee to substantiate the inclusion of this company.

Whether profit margin of the assessee, which is only rendering back office support services cannot be compared with the Accentia Technologies Ltd, since segmental information for each streams of income of latter is not available - YES: ITAT

++ Accentia Technologies Ltd. has two main business areas namely, health care receivable cycle management services and software products for BPOs. It earns substantial part of its income from coding activities which is primarily related to e-software development. Various streams of income shown in the annual report reflects that it has income from medical transcription, billing and collections, income from coding, etc. It is not in dispute that segmental information for each streams of income are not available, therefore, it would be very difficult to benchmark profit margin with the assessee-company, which is only rendering back office support services. Another important fact which is borne out from the its annual report is that, during the year under consideration, assessee has acquired business of Oak Technologies Inc. USA which has led to rapid increase in its customer base. Such acquisition definitely has an impact on the trading result and can distort profit margin. Thus, Accentia Technologies Ltd. cannot be included in the list of final comparables and accordingly, the same is directed to be excluded.

Whether the fact that Cosmic Global Ltd continues to be part of assessee's comparable in subsequent years, and assessee has failed to demonstrated any change in business model, it cannot be allowed to resort to such cherry picking by pleading for exclusion this year - YES : ITAT

+ the assessee has sought exclusion of this comparable company mainly on the ground that it outsources most of its work which is 57.31% as compared to the assessee which is only 2.5% and employee cost of this company is lower. Though this is fairly a vital factor vitiating the comparability, however, the assessee could not give any rebuttal or any cogent reasons as to why this comparable company was selected and chosen by the assessee after carrying out FAR analysis not only in earlier years, but also in subsequent assessment years i.e. 2010-11 and 2011-12 again on carrying same FAR analysis. It is only in this year that assessee is seeking exclusion on the ground that it has a different business model. Such pick and choose of comparables every year according to the suitability of the margin definitely amounts to cherry picking. The assessee has not demonstrated before us that in earlier years and subsequent years the business model of Cosmic Global Ltd. is different, i.e., it does not outsource its substantial work. No doubt assessee can object to inclusion or exclusion of a comparable company contrary to its TP Study Report by citing cogent grounds and pointing out the factors vitiating the comparability and TPO has to examine these comparability factors on merits, but when assessee consistently adopts any comparable company and too after FAR scrutiny then onus is very heavy upon the assessee to substantiate that the material factors in this year are different from the years when it seeks to take contrary stand in a particular year. The assessee has been unable to point out the material factors for distinction sought in this year was not permeating in the earlier years or in the subsequent years. This inconsistent approach cannot be permitted as it can lead to falling in the realm of whims of suitability of assessee. Had it been the case where material facts were different in this year and the comparable has been selected on some incorrect analysis in the earlier year or at the time of TP study, then definitely there cannot be any estoppel for objecting to for exclusion, but such material facts and incorrect approach has to be demonstrated which has not been done in this year. This inconsistency is further accentuated by the fact that this comparable continues to be part of assessee's comparable in subsequent years. Thus, we agree with the contention of the Revenue that assessee cannot be allowed to resort to such cherry picking. Accordingly, we confirm the action of the TPO in including Cosmic Global Ltd. as comparable following rule of consistency

Whether since eClerx Services Ltd is a KPO Company which outsources its substantial work and assessee on the other hand is providing back office support services provided by its own human resources, TPO is expected to exclude this comparable from the list - YES : ITAT

+ due to its exceptional performance during the year, eClerx Services Ltd has been chosen as best KPO Company and it has also outsourced its substantial work to the third party during the year. The assessee on the other hand is providing back office support services and such services are being provided by its own human resources, that is, it is not outsourcing its work. Tthe Delhi High Court in the case of Ramp Green Solutions Pvt. Ltd. has directed the TPO to exclude this company on the ground that it is providing KPO services and most of its work was outsourced to other service providers which affects the profitability. Thus, respectfully following the judgment of the Delhi High Court the TPO was directed to exclude this comparable from the comparability list.

+ Vishal Info Tech. (Coral Hub) has a different business model inasmuch as its outsourcing charges is 90.57% which reflects that it has a different business model all together and deployment of human resources in an outsourcing model definitely is different from a company which carries its work through its own resources and there is huge difference in employees cost ratio to turnover. Thus, in the outsourcing model, the assets deployed (in the form of human resources) and other intangible differs from an entity which operates mostly on its own resources. The ratio laid down by the Delhi High Court in the case of Ramp Green Solutions Pvt. Ltd. is clearly applicable and accordingly, TPO was directed to exclude this company from the list of final comparable.

Whether unless assets and risk are completely different, a company cannot be held to be incomparable merely on the ground of low turnover - YES: ITAT

+ the main reason for not including this company is that its turnover is less than Rs 1 crore. So far as exclusion of this comparable on basis of turnover filter criteria of less than Rs. 1 crore, we find that, first of all, it was a comparable chosen by the assessee and at the time of selection process the assessee as stated had not applied any turnover filter for accepting or rejecting the comparables. Once the turnover filter has not been applied at the quantitative level then comparability has to be done on qualitative level based on FAR analysis. If on FAR analysis it is found that there are differences on account of either assets deployed, risk assumed materially affecting the cost or margin then only comparability analysis fails in such cases. Further, under the TNMM, the comparability of an international transaction with an uncontrolled transaction is to be seen with reference to functions performed after taking into assets employed and the risk assumed. While reckoning the comparability analysis under TNMM, the main emphasis is into net margin realized on the transactions undertaken and not the price of the product or services. The transfer pricing rules under Rule 10B and 10C also contemplate for eliminating the material effects and to make reasonably accurate adjustment for eliminating the differences on account of such material effects. Mere circumstance of a company which otherwise confirm to the comparability analysis in terms of Rule 10B(2) and (3), huge profit or huge turnover ipso facto does not lead to its exclusion unless and of course it is shown that turnover or huge profit is on account of factor leading to a different results in FAR analysis. We find that the Delhi High Court in the case of Cryscapital Investment Advisors India Pvt. Ltd. vs. DCIT after detailed analysis of rule 10B(3), same principle has been reiterated that if the company is functionally comparable then same cannot be rejected on the basis of turnover. The High Court in its very detailed judgment wherein it was required to answer, whether the comparable can be rejected on the ground that they have high profit margin as compared to the assessee in TP analysis, has also dealt upon the turnover factor in detail and reiterated that if the company is functionally comparable then same cannot be rejected on the basis of turnover. Thus, following the ratio laid down by the Delhi High Court, the company cannot be held to be incomparable simply on the ground of low turnover, unless it is demonstrated that the assets and risk are completely different and are incomparable. Thus, the TPO was directed to include CG Vak Software And Exports Ltd. as a comparable company.

Whether comparability under TP analysis cannot be rejected merely on ground that the companies have different financial year, since financials of the corresponding period is available - YES : ITAT

+ R-Systems has been rejected not on the ground of functionality albeit on the ground that it is following the financial year accounting from January to December (i.e., calendar year). Though a comparable company following a different financial year may not be generally taken for comparability analysis, however, if financial data is available for all the quarters including January to March and it is otherwise possible to determine the value of the transaction as well as the profitability during the corresponding period, then it suffices the comparability criteria. Because, ultimately the core point in comparability analysis is to benchmark the margin of a given period of a comparable uncontrolled transaction with controlled transaction. If the financials of the corresponding period is available then it cannot be rejected simply on the ground that it has a different financial year. As brought out on record before us submitted that the audited accounts of RSystems for the year ending 31.12.2008 and for the quarter starting from 31.01.2008 to 31.03.2009 is available and once such an audited statement is available, then the proportionate working for 31.03 2009 can easily be deduced. If there are no major incident of factors disturbing the profit margin in that quarter, whose results are being worked out and the transactions of the Company are carried out in the normal course of business, then there is no reason to reject the comparable out rightly on the aforesaid ground. The working of PLI based on audited accounts as incorporated above clearly clinches the point.

Assessee's appeal partly allowed