Actis Advisers P. Ltd. v. Dy. CIT

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The Tax Publishers2013 TaxPub(DT) 0209 (Del-Trib) : (2012) 020 ITR (Trib) 0138 INCOME TAX ACT, 1961 --Transfer pricing--Computation of ALP Selection of comparable--According to assessee, it net profit margin was within the range of 5 per cent of the average profit margin worked out by it, therefore, its value of international transaction with AEs was at the arm's length price and did not require any adjustment. The assessee selected 22 comparables. The assessee applied following filters companies with ratio of other operating income to sales greater than 590 per cent, were selected companies with ratio of research and development expenses to sales greater than 3 per cent were rejected. Companies with the ratio of fixed assets to sale grater than 200 per cent were rejected companies with ratio of sum of advertising marketing and distribution expense to sales less than or equal to 3 per cent were selected. The assessing officer made reference to TPO to compute ALP of assessee's international transaction with AEs. *Held:* assessing officer was to grant working capital adjustment after considering the computation filed by assessee before the DRP. If comparable which had incurred more than 5 per cent of sales as expenses towards advertisement and marketing were selected there was, therefore, no case for excluding 'A+' from list of comparables. TPO was right in excluding only companies having related parties transactions in excess of 25 per cent of operating revenue. Moreover, in view of companies having turnover of more than Rs. 260 crores would not be considered as comparable companies. For carrying out any business, an assessee would always require the capital. Now, it is for the assessee to contribute the capital from its own source or borrow it from a financial institution. If the capital is borrowed from the financial institution, it will be serviced by interest, etc. and which will ultimately affect the profit ratio. In a given case, an assessee has surplus capital from reserve, share capital etc. but still it operates its activity from the borrowed fund, then on the surplus capital, it would earn interest income which is independent to the operation of the company. Such income would be assessed as income from other sources, but the profit margin from the operations would be on lower side because of interest expenses, etc. Thus, the working capital as envisaged by the assessee would always affect its profit. If the assessee was not required to use its own working capital then it will be a relevant factor for determining the profit margin and an adjustment to eliminate the disparity would always required. Considering the stand of the learned Transfer Pricing Officer in the assessment years 2007-08 and 2008-09 where benefit of working capital adjustment was granted to the assessee, we allow this plea of the assessee and set aside the issue to, the file of the assessing officer with a direction that the assessing officer shall grant working capital adjustments, after considering the computation filed by the assessee before the Dispute Resolution Panel. In case, it is felt that from that computation, it is difficult to draw conclusion then, the assessing officer may ask the assessee to file, fresh working. [Para 20] The assessee has not applied the filter, i.e., the companies who have incurred expenses of more than 5 per cent, of its sales on advertisement and marketing which required to be excluded. At this stage, in the absence of any finding, at the level of the Transfer Pricing Officer or of the learned Dispute Resolution Panel, it is difficult to verify the version put forth by learned counsel for the assessee. Apart from this, at the cost of repetition, we would like to observe that profit margin of any company is dependent upon many factors. By taking into consideration the one aspect, if we keep on excluding the comparables then not a single comparable would be identified. The simple reason is whenever any adjudicating authority would try to carry out a study of the result of any company with a particular angle then the result would be different. The assessee ought to have placed specific details before the learned Transfer Pricing Officer and demonstrated how a prejudice had been caused to the assessee, if comparables which have incurred more than 5 per cent, of sales expenses towards advertisement and marketing are selected. Therefore, we do not find any merit in the contentions of counsel for the assessee for excluding A Ltd. from the-list of comparables. [Para 22] Profit and loss are two incidence of business and merely oh account of low profit or loss would not make a functional comparables company as uncomparable, but if the ultimate result is of such a nature which demonstrates that such company is not comparable then that company deserves to be excluded, e.g., a company may be functionally comparable but if it is showing persistent losses then it is always advisable to exclude such a company from the list of comparable. Similarly, if the result of a company over a period shows fluctuation disproportionate to other concern, then that would not be an indicator for the profit or loss resulting from the operation of the company rather some extra reasons would be responsible for the losses or the profit. Therefore, such comparable deserves to be excluded. Maple e-Solutions has shown 100 per cent, loss in the financial year 2002-03 but all of a sudden showed profit at 37.38 per cent, in the financial year 2004-05. In the financial year 2008-09, it again showed losses and its profit margin is -65.23 per cent. Considering this aspect, we are of the view that this comparable deserves to be excluded from the list of comparables. With the above observations, the issue as set aside to the file of the assessing officer for re-adjudication. The assessing officer shall give working capital adjustments to the assessee in the assessment year 2006-07. He shall work out the average profit margin of the comparables after excluding Maple e-Solutions. The appeal for the assessment year 2006-07 is accordingly allowed for statistical purposes. [Para 24] On due consideration of the assessee's objections, the learned Transfer Pricing Officer has observed that the operative force of the assessee's contention is that marketing and advertisement, activities carried out by the comparable companies result in creation of marketing intangible, which would give return on such investment. In other words, the expenses incurred on advertisement and marketing creates a marketing intangible. The Transfer Pricing Officer rejected this contentions on the ground that such an argument is not based on any substantial analysis. The assessee made reference to Wipro and Flex Tronic Software System and submitted that these companies have created marketing intangible, therefore, they are earning more profit than any other captive entity. The learned Transfer Pricing Officer rejected the contention of the assessee on the ground that 95 per cent, of the revenue of Infosys is from repeat business. The marketing intangible did not help Infosys to get any better business according to the Transfer Pricing Officer. On an analysis of the learned Transfer Pricing Officer's order coupled with the contentions of the assessee, we are of the view that the learned Transfer Pricing Officer has rightly observed that in the case of manufacturing or distribution companies marketing expenses over a period of time may create marketing intangible which will be helpful to them for getting better business but it may not be applicable with equal force on service industries like information technology enabled services. The instances of Infosys referred to by the assessee has been specifically dealt with by the learned Transfer Pricing Officer, he has reproduced relevant portion of the annual report of Infosys on page 25. For buttressing this plea, counsel for the assessee mainly gave two explanation. In his first reasoning he pointed out that profit ratio of the companies who have incurred expenses less than 3 per cent, of the sales is 22,26 per-cent. The companies who have incurred expenses more than 3 per cent, but less than 5 per cent, of the sales on AMP, their profit is 45:52'per cent. Similarly, the companies who have incurred expenses on AMP, at 5 per cent, to 7 per cent, of sales, the profit is between 67.46 per' cent, 'These, figures have been put from the result of comparable. We have extracted such comparable in paragraph 24 on page 36 of this Order. Contrary to this, the Departmental representative also pointed out that HCL incurred 0.65 per cent, of sales on AMP but has shown profit at 45.91 per cent. Similarly, Maple e-Solution incurred 0.16 per cent, and shown profit at 32.06 per cent. Visual Infratech did not incur any expenditure but has shown profit at 44.15 per cent. Thus; the details referred to by learned counsel for the assessee do not advance the case of the assessee. What is the actual impact on the earning of income could not be demonstrated on the basis of these comparative details, graph, etc. The next reasoning is that such companies are functionally different. Creation of marketing intangible is brand by incurring such expenses may be helpful in future. But how their FAR is substantially so different could not be explained. The Transfer Pricing Officer has looked into this aspect. He observed that material showing impact on information and technology industry by such expenses had not been produced by the assessee. After taking into consideration the discussion made by the learned Transfer Pricing Officer as well as the Dispute Resolution Panel on this issue, we do not find any merit in the contentions of learned counsel for the assessee for exclusion of eight companies, from the list of comparables. [Para 28] The Act does. not provide directly as to what percentage of a related party transaction has to be considered for exclusion. However, if Tribunal look to the scheme of the Income-tax Act, then it would be revealed that expression 'associate enterprises' which is somewhat similar to that of 'related party', has been defined in section 92A(2) (a) of the Act. According to this definition, if an enterprise holds 26 per cent, share in the other enterprise then it can be considered as an associate enterprise. Similarly, under section 40A(2)(b) of the Act, interested persons has been explained, if a person is having not less than 20 per cent, of the voting power in a company then such person would be considered as having substantial interest in the company. This section relates to examination of the cases where some undue benefit is being extended by a company. These two provisions give an indicator that whenever any issue regarding an interest created in any company is being examined which has influenced the results of the company then these aspects can be taken as guidance. On the basis of the scheme, one can safely say that an entity can be taken as uncontrolled, if its related party transaction do not exceed 25 per cent, of the total revenue. Thus, there is no fault in the conclusion of the Transfer Pricing Officer for applying this filter to the extent of 25 per cent. Transaction with related party of the total revenue. The contentions raised by counsel for the assessee in this regard are rejected. [Para 31] However, we find that the three companies which have been pointed out by the assessee are very large companies who have a turnover of more than Rs. 260 crores. They cannot be considered as a comparable companies, in view of their huge turnover. Therefore, there is force in the contentions of learned counsel for the assessee and direct the assessing officer to exclude these three comparables and thereafter reworked out the means profit of the comparables. [Para 32] Profit and loss are two incidence of the business and merely on account of low profit or loss would not make a functional comparables companies as un-comparable, but if the ultimate, result is of such a nature which demonstrates that such companies are not comparable then that company deserves to be excluded. If the result of a company over a period shows fluctuation and such result is disproportionate to other concern then that would be an indication that profit or loss may not be resulting from the operation of the company alone, rather there may be some extra reasons for such losses or profit. Therefore, Vishal Information Technology is consistent in its result and it cannot be excluded from the comparables: In the assessment year 2006-07, Tribunal has excluded. This year also, it will be excluded. As far as I Service India, P. Ltd. is concerned, there is no information with regard to the earlier years and financial year 2006-07 is the first year. Therefore, it cannot be said that this company has shown vast fluctuation. In view of the above discussion, we partly accept the contentions of counsel for the assessee in this fold of arguments and only exclude M from the comparable. [Para 35] SUBSCRIBE FOR FULL CONTENT

The Tax Publishers2013 TaxPub(DT) 0209 (Del-Trib) : (2012) 020 ITR (Trib) 0138

INCOME TAX ACT, 1961

--Transfer pricing--Computation of ALP Selection of comparable--According to assessee, it net profit margin was within the range of 5 per cent of the average profit margin worked out by it, therefore, its value of international transaction with AEs was at the arm's length price and did not require any adjustment. The assessee selected 22 comparables. The assessee applied following filters companies with ratio of other operating income to sales greater than 590 per cent, were selected companies with ratio of research and development expenses to sales greater than 3 per cent were rejected. Companies with the ratio of fixed assets to sale grater than 200 per cent were rejected companies with ratio of sum of advertising marketing and distribution expense to sales less than or equal to 3 per cent were selected. The assessing officer made reference to TPO to compute ALP of assessee's international transaction with AEs. Held: assessing officer was to grant working capital adjustment after considering the computation filed by assessee before the DRP. If comparable which had incurred more than 5 per cent of sales as expenses towards advertisement and marketing were selected there was, therefore, no case for excluding 'A+' from list of comparables. TPO was right in excluding only companies having related parties transactions in excess of 25 per cent of operating revenue. Moreover, in view of companies having turnover of more than Rs. 260 crores would not be considered as comparable companies.

For carrying out any business, an assessee would always require the capital. Now, it is for the assessee to contribute the capital from its own source or borrow it from a financial institution. If the capital is borrowed from the financial institution, it will be serviced by interest, etc. and which will ultimately affect the profit ratio. In a given case, an assessee has surplus capital from reserve, share capital etc. but still it operates its activity from the borrowed fund, then on the surplus capital, it would earn interest income which is independent to the operation of the company. Such income would be assessed as income from other sources, but the profit margin from the operations would be on lower side because of interest expenses, etc. Thus, the working capital as envisaged by the assessee would always affect its profit. If the assessee was not required to use its own working capital then it will be a relevant factor for determining the profit margin and an adjustment to eliminate the disparity would always required. Considering the stand of the learned Transfer Pricing Officer in the assessment years 2007-08 and 2008-09 where benefit of working capital adjustment was granted to the assessee, we allow this plea of the assessee and set aside the issue to, the file of the assessing officer with a direction that the assessing officer shall grant working capital adjustments, after considering the computation filed by the assessee before the Dispute Resolution Panel. In case, it is felt that from that computation, it is difficult to draw conclusion then, the assessing officer may ask the assessee to file, fresh working. [Para 20] The assessee has not applied the filter, i.e., the companies who have incurred expenses of more than 5 per cent, of its sales on advertisement and marketing which required to be excluded. At this stage, in the absence of any finding, at the level of the Transfer Pricing Officer or of the learned Dispute Resolution Panel, it is difficult to verify the version put forth by learned counsel for the assessee. Apart from this, at the cost of repetition, we would like to observe that profit margin of any company is dependent upon many factors. By taking into consideration the one aspect, if we keep on excluding the comparables then not a single comparable would be identified. The simple reason is whenever any adjudicating authority would try to carry out a study of the result of any company with a particular angle then the result would be different. The assessee ought to have placed specific details before the learned Transfer Pricing Officer and demonstrated how a prejudice had been caused to the assessee, if comparables which have incurred more than 5 per cent, of sales expenses towards advertisement and marketing are selected. Therefore, we do not find any merit in the contentions of counsel for the assessee for excluding A Ltd. from the-list of comparables. [Para 22] Profit and loss are two incidence of business and merely oh account of low profit or loss would not make a functional comparables company as uncomparable, but if the ultimate result is of such a nature which demonstrates that such company is not comparable then that company deserves to be excluded, e.g., a company may be functionally comparable but if it is showing persistent losses then it is always advisable to exclude such a company from the list of comparable. Similarly, if the result of a company over a period shows fluctuation disproportionate to other concern, then that would not be an indicator for the profit or loss resulting from the operation of the company rather some extra reasons would be responsible for the losses or the profit. Therefore, such comparable deserves to be excluded. Maple e-Solutions has shown 100 per cent, loss in the financial year 2002-03 but all of a sudden showed profit at 37.38 per cent, in the financial year 2004-05. In the financial year 2008-09, it again showed losses and its profit margin is -65.23 per cent. Considering this aspect, we are of the view that this comparable deserves to be excluded from the list of comparables. With the above observations, the issue as set aside to the file of the assessing officer for re-adjudication. The assessing officer shall give working capital adjustments to the assessee in the assessment year 2006-07. He shall work out the average profit margin of the comparables after excluding Maple e-Solutions. The appeal for the assessment year 2006-07 is accordingly allowed for statistical purposes. [Para 24] On due consideration of the assessee's objections, the learned Transfer Pricing Officer has observed that the operative force of the assessee's contention is that marketing and advertisement, activities carried out by the comparable companies result in creation of marketing intangible, which would give return on such investment. In other words, the expenses incurred on advertisement and marketing creates a marketing intangible. The Transfer Pricing Officer rejected this contentions on the ground that such an argument is not based on any substantial analysis. The assessee made reference to Wipro and Flex Tronic Software System and submitted that these companies have created marketing intangible, therefore, they are earning more profit than any other captive entity. The learned Transfer Pricing Officer rejected the contention of the assessee on the ground that 95 per cent, of the revenue of Infosys is from repeat business. The marketing intangible did not help Infosys to get any better business according to the Transfer Pricing Officer. On an analysis of the learned Transfer Pricing Officer's order coupled with the contentions of the assessee, we are of the view that the learned Transfer Pricing Officer has rightly observed that in the case of manufacturing or distribution companies marketing expenses over a period of time may create marketing intangible which will be helpful to them for getting better business but it may not be applicable with equal force on service industries like information technology enabled services. The instances of Infosys referred to by the assessee has been specifically dealt with by the learned Transfer Pricing Officer, he has reproduced relevant portion of the annual report of Infosys on page 25. For buttressing this plea, counsel for the assessee mainly gave two explanation. In his first reasoning he pointed out that profit ratio of the companies who have incurred expenses less than 3 per cent, of the sales is 22,26 per-cent. The companies who have incurred expenses more than 3 per cent, but less than 5 per cent, of the sales on AMP, their profit is 45:52'per cent. Similarly, the companies who have incurred expenses on AMP, at 5 per cent, to 7 per cent, of sales, the profit is between 67.46 per' cent, 'These, figures have been put from the result of comparable. We have extracted such comparable in paragraph 24 on page 36 of this Order. Contrary to this, the Departmental representative also pointed out that HCL incurred 0.65 per cent, of sales on AMP but has shown profit at 45.91 per cent. Similarly, Maple e-Solution incurred 0.16 per cent, and shown profit at 32.06 per cent. Visual Infratech did not incur any expenditure but has shown profit at 44.15 per cent. Thus; the details referred to by learned counsel for the assessee do not advance the case of the assessee. What is the actual impact on the earning of income could not be demonstrated on the basis of these comparative details, graph, etc. The next reasoning is that such companies are functionally different. Creation of marketing intangible is brand by incurring such expenses may be helpful in future. But how their FAR is substantially so different could not be explained. The Transfer Pricing Officer has looked into this aspect. He observed that material showing impact on information and technology industry by such expenses had not been produced by the assessee. After taking into consideration the discussion made by the learned Transfer Pricing Officer as well as the Dispute Resolution Panel on this issue, we do not find any merit in the contentions of learned counsel for the assessee for exclusion of eight companies, from the list of comparables. [Para 28] The Act does. not provide directly as to what percentage of a related party transaction has to be considered for exclusion. However, if Tribunal look to the scheme of the Income-tax Act, then it would be revealed that expression 'associate enterprises' which is somewhat similar to that of 'related party', has been defined in section 92A(2) (a) of the Act. According to this definition, if an enterprise holds 26 per cent, share in the other enterprise then it can be considered as an associate enterprise. Similarly, under section 40A(2)(b) of the Act, interested persons has been explained, if a person is having not less than 20 per cent, of the voting power in a company then such person would be considered as having substantial interest in the company. This section relates to examination of the cases where some undue benefit is being extended by a company. These two provisions give an indicator that whenever any issue regarding an interest created in any company is being examined which has influenced the results of the company then these aspects can be taken as guidance. On the basis of the scheme, one can safely say that an entity can be taken as uncontrolled, if its related party transaction do not exceed 25 per cent, of the total revenue. Thus, there is no fault in the conclusion of the Transfer Pricing Officer for applying this filter to the extent of 25 per cent. Transaction with related party of the total revenue. The contentions raised by counsel for the assessee in this regard are rejected. [Para 31] However, we find that the three companies which have been pointed out by the assessee are very large companies who have a turnover of more than Rs. 260 crores. They cannot be considered as a comparable companies, in view of their huge turnover. Therefore, there is force in the contentions of learned counsel for the assessee and direct the assessing officer to exclude these three comparables and thereafter reworked out the means profit of the comparables. [Para 32] Profit and loss are two incidence of the business and merely on account of low profit or loss would not make a functional comparables companies as un-comparable, but if the ultimate, result is of such a nature which demonstrates that such companies are not comparable then that company deserves to be excluded. If the result of a company over a period shows fluctuation and such result is disproportionate to other concern then that would be an indication that profit or loss may not be resulting from the operation of the company alone, rather there may be some extra reasons for such losses or profit. Therefore, Vishal Information Technology is consistent in its result and it cannot be excluded from the comparables: In the assessment year 2006-07, Tribunal has excluded. This year also, it will be excluded. As far as I Service India, P. Ltd. is concerned, there is no information with regard to the earlier years and financial year 2006-07 is the first year. Therefore, it cannot be said that this company has shown vast fluctuation. In view of the above discussion, we partly accept the contentions of counsel for the assessee in this fold of arguments and only exclude M from the comparable. [Para 35]