Introduction

The case of Micro Focus Software India Private Limited, Bangalore v. Assistant Commissioner of Income-Tax, Bangalore (IT(TP)A No.368/Bang/2017) adjudicated by the Income Tax Appellate Tribunal (ITAT) on March 17, 2020, is a pivotal decision in the realm of transfer pricing, particularly concerning Software Development (SWD) and Information Technology Enabled Services (ITES) sectors. The appellant, Micro Focus Software India Pvt. Ltd., challenged the assessment order for the assessment year 2012-13, which included significant transfer pricing adjustments and disallowances under various sections of the Income Tax Act, 1961.

The core issues revolved around the appropriateness of the Transfer Pricing Officer's (TPO) selection of comparable companies, the methodologies employed for transfer pricing adjustments in the SWD and ITES segments, and the disallowance of certain expenditures under section 14A. The appellant contended that the adjustments made were arbitrary and not reflective of arm's length transactions, urging the Tribunal to reconsider the comparability criteria and methodological applications.

Summary of the Judgment

The ITAT bench, comprising Shri N.V. VasuDevan and Shri B.R. Bakkaran, examined the appellant's challenges in detail. The Tribunal evaluated the TPO's transfer pricing adjustments in both the Software Development and ITES segments, scrutinizing the selection and exclusion of comparable companies. Key findings include:

• Software Development Segment: The Tribunal upheld the TPO's exclusion of certain companies from comparability based on functional dissimilarities and segmental data availability, despite the appellant's objections.
• ITES Segment: The Tribunal partially agreed with the appellant, directing a fresh examination of certain comparable companies while upholding the exclusion of others based on established precedents.
• Disallowance under Section 14A: The Tribunal sided with the appellant, directing the removal of disallowed amounts as the appellant did not earn any exempt income.
• Other Grounds: Issues like non-set-off of brought forward losses, non-grant of MAT credit, and short grant of TDS credit were restored to the Assessing Officer's file for further scrutiny.

Ultimately, the Tribunal allowed the appeal for statistical purposes, reversing certain transfer pricing adjustments and disallowances while upholding others based on adherence to precedents and regulatory frameworks.

Analysis

Precedents Cited

The Tribunal extensively referenced previous cases to determine the comparability of companies for transfer pricing purposes. Notable precedents include:

• CGI Information Systems & Management Consultants Pvt. Ltd. (2018) 94 taxmann.com 97: This case guided the exclusion of certain companies from comparability due to their engagement in software product development and lack of segmental reporting.
• Baxter (I) (P) Ltd v. A.CIT (2017) 85 taxmann.com 285: Emphasized the importance of brand value, revenue consistency, and functional alignment in selecting comparable companies.
• M/s Zyme Solutions Pvt. Ltd. (IT(TP)A No.1661/Bang/2016) (28-06-2019): Highlighted the necessity of functional comparability over mere business classification in excluding companies from comparables.
• Cheminvest Ltd v. CIT (2015) 61 taxmann.com 118: Influenced the Tribunal's decision to delete the disallowance under section 14A in the absence of exempt income.

These precedents underscored the critical evaluation of functional profiles, asset utilization, risk assumption, and revenue composition in determining comparable companies for transfer pricing adjustments.

Legal Reasoning

The Tribunal's legal reasoning was rooted in the adherence to the Income Tax Act's transfer pricing provisions, specifically the application of Rule 10B of the Income Tax Rules, 1962, which delineates the methodologies and criteria for determining arms-length prices. Key aspects of the legal reasoning include:

• Transfer Pricing Methodology: The Tribunal evaluated the appropriateness of the Transactional Net Margin Method (TNMM) employed by the appellant, assessing the Profit Level Indicator (PLI) and the selection of comparable companies.
• Comparability Assessment: Detailed examination of the appellant's comparable companies led to the exclusion of those lacking functional, asset, and risk alignment, as mandated by regulatory precedents.
• Segmental Reporting: The absence of segmental data in certain companies was a pivotal factor in determining comparability, aligning with the stipulations of Rule 10B(2).
• Exempt Income Disallowance: The Tribunal reasoned that in the absence of evidence supporting exempt income, the disallowance under section 14A was unjustified, referencing judicial decisions that support such a stance.

The Tribunal meticulously balanced the TPO's assessments with established legal standards, ensuring that adjustments were justifiable and based on sound comparability principles.

Impact

This judgment has significant implications for the transfer pricing landscape in India, especially for companies operating in the SWD and ITES sectors:

• Enhanced Scrutiny on Comparables: Companies must ensure rigorous alignment of functional profiles, asset composition, and risk profiles when selecting comparables to withstand scrutiny.
• Importance of Segmental Data: The necessity for detailed segmental reporting is emphasized, as its absence can lead to exclusion from comparability sets.
• Precedent for Exempt Income Disallowance: Upholding the disallowance only when exempt income is substantiated sets a clear precedent, protecting taxpayers from arbitrary disallowances.
• Guidance on Methodological Applications: The Tribunal's support for specific transfer pricing methodologies and the evaluation of their application provides clear guidance for future transfer pricing audits and appeals.

Overall, the judgment reinforces the necessity for transparency, detailed reporting, and adherence to established comparability criteria in transfer pricing practices.

Complex Concepts Simplified

Transfer Pricing (TP)

Transfer Pricing refers to the rules and methods for pricing transactions between related entities within a multinational enterprise, ensuring that profits are appropriately allocated and taxed where economic activities occur.

Transactional Net Margin Method (TNMM)

TNMM is a transfer pricing method that examines the net profit margin relative to an appropriate base (e.g., costs, sales) that a taxpayer realizes from a controlled transaction. It compares this margin to that of independent entities to determine arm's length compliance.

Profit Level Indicator (PLI)

PLI is a metric used in transfer pricing to assess profitability. It often refers to ratios like return on sales, which indicate whether the profit margin of a controlled transaction aligns with those of comparable uncontrolled transactions.

Comparable Companies:

These are independent entities that perform similar functions, use similar assets, and assume similar risks as the taxpayer, making them suitable benchmarks for assessing arm's length prices in transfer pricing analysis.

Rule 10B of the Income Tax Rules, 1962

Rule 10B provides the framework for determining arm's length prices for international and specified domestic transactions. It outlines the prescribed methods, selection of comparables, and conditions under which adjustments may be made.

Section 14A of the Income Tax Act, 1961

This section deals with disallowance of expenditure incurred on foreign travel, which is not directly related to the assessment or business operations, unless proven otherwise.

Conclusion

The ITAT's decision in Micro Focus Software India Pvt. Ltd. v. Assistant Commissioner of Income-Tax serves as a critical juncture in the interpretation and application of transfer pricing regulations within the IT and software sectors. By meticulously analyzing the comparability of companies based on functional profiles, asset utilization, and segmental reporting, the Tribunal has reinforced the necessity for precise and substantiated transfer pricing studies. The affirmation of precedents and the emphasis on methodological rigor provide a clear roadmap for corporations to align their transfer pricing practices with regulatory expectations. Moreover, the judgment underscores the importance of accurate reporting and the potential repercussions of neglecting detailed segmental data, thereby shaping future compliance and audit strategies in the dynamic landscape of international taxation.