Dr. O.K. Narayanan, Vice President. - These are two appeals filed by the assessee and the revenue. These cross appeals relate to the assessment year 2003-04. The appeals are directed against the order of the CIT(A)-IV at Bangalore dated 28-1-2008 and arise out of the assessment completed under section 143(3) of the Income-tax Act, 1961.

2. The assessee, M/s. SAP Labs India Pvt. Ltd., is a wholly owned subsidiary of a German Company, SAP AG. SAP AG develops software products under the brand name of SAP. The software products are sold world wide. SAP AG has established development centers throughout the world for developing the necessary software. The assessee in the present case is one of such development centers established by SAP AG in India as 100 per cent Export Oriented Unit (EOU). The assessee has obtained the EOU status under the software technology parks [STP] Scheme of the Government of India. The principal business carried on by the assessee in India is providing software development and related services to its associate concern SAP AG. In order to deliver the above-mentioned services, the assessee has entered into an R & D agreement with SAP AG. As per the agreement, the assessee-company is to be paid remuneration by SAP AG on cost plus basis. In this case, it is cost plus 6 per cent or 1.5 times of the wages bill of assessee-company, whichever is higher.

3. The assessee-company has returned a loss of Rs. 7,57,430 for the assessment year under appeal. The activity of the assessee-company being to provide software development support to SAP AG, it has resulted in overseas transactions and such export turnover exceeded Rs. 5 crores. The Assessing Officer has referred the case to the Transfer Pricing Officer (TPO) to decide the Arms Length Price (ALP), so as to proceed in the assessment.

4. The assessee has accounted for an operating revenue of Rs. 71,69,87,294. The operating cost as per the books of account worked out to Rs. 68,00,34,163. The operating profit declared by the assessee is Rs. 4,85,08,975 but revised by the TPO to Rs. 3,69,53,131. According to the TPO, this revised profit before interest tax works out to an operating profit ratio of 5.43 per cent. On studying the above variables, the TPO concluded that the margin disclosed by the assessee is far below the margin reflected in comparable cases. The TPO has adopted Transactional Net Margin Method (TNMM) as the Most Appropriate Method (MAM) to make the analysis. On the basis of the comparative analysis made by the TPO under TNMM, the percentage of profit to the cost of international transaction has been worked out to 22.24 per cent. This is against the margin of 5.43 per cent noted by the TPO on the basis of the accounts of the assessee-company. The TPO adopted the percentage of profit at 22.24 per cent and worked out the Arm’s Length Revenue attributable to the assessee-company. This revenue has been worked out at Rs. 83,12,73,760. The operating revenue reported by the assessee as per the books of account is Rs. 71,69,87,294. The differential amount is Rs. 11,42,86,466. The TPO quantified the ALP adjustment to the above differential amount of Rs. 11,42,86,466 under section 92CA of the Income-tax Act, 1961. When this ALP adjustment was placed before the assessee-company, a series of objections were raised before the TPO. The assessee had a lot of grievances regarding the filtering of comparable cases on a turnover basis adopted by the TPO and working out the revenue and cost without excluding extraordinary items and for the disparity in the selection of comparable cases. The objections were ruled out. The assessing authority, therefore, treated this ALP adjustment of Rs. 11,42,86,466 as the taxable income of the assessee-company under section 92C(4) of the Income-tax Act, 1961.

5. Another addition made by the assessing authority is an amount of Rs. 1.05 crores. The assessee had paid a compensation of Rs. 1 crore on termination of a property purchase agreement. In addition to the compen- sation of Rs. 1 crore, the assessee had also paid service tax at 5 per cent amounting to Rs. 5 lakhs. The total payment of Rs. 1.05 crores was claimed as deduction in computing the taxable income. The Assessing Officer held that the expenditure was capital in nature and, therefore, cannot be deducted in computing the income. The said amount was added back.

6. As already stated, the assessee-company is an Export Oriented Undertaking (EOU) and, therefore, claimed deduction under section 10A. The total turnover of the assessee was Rs. 72,70,35,620. The domestic turnover amounted to Rs. 40,24,688. The balance of Rs. 72,30,10,932 was shown as export turnover. In carrying on the said business, the assessee has incurred an amount of Rs. 1,98,74,061 as communication expenses. Out of the above expenses, Rs. 71,66,003 related to lease line charges. The Assessing Officer treated 50 per cent of the above amount which works out to Rs. 35,83,000 as lease line charges incurred for the purpose of export turnover of the assessee-company. He, therefore, reduced the export turnover of the assessee-company by the said amount of Rs. 35,83,000. An alternative contention placed by the assessee-company before the Assessing Officer was that a corresponding deduction should be made out of the total turnover as well. But this contention was rejected by the assessing authority. The deduction was made only from the export turnover.

7. With the above adjustment, addition and disallowance, the Assessing Officer determined the total income of the assessee at Rs. 12,39,08,030 as against a loss of Rs. 7,57,430 returned by the assessee-company.

8. The assessment was taken in first appeal before the CIT(A). In the matter of transfer pricing adjustment, the CIT(A) rejected the grounds raised by the assessee-company and confirmed the finding of the TPO vis-a-vis order of the assessing authority. The CIT(A) held that the price of international transactions of software development and consultancy rendered by the assessee-company to SAG AG was not at arm’s length, inasmuch as the net margin reported by the assessee-company on operating costs worked out to 5.43 per cent only. In respect of the disallowance of compensation charges paid by the assessee on termination of the property purchase agreement, the CIT(A) held that the payment was towards a capital expenditure and, therefore, the Assessing Officer was right in disallowing the claim of deduction. As far as the exclusion of lease line charges from the export turnover is concerned, the CIT(A) accepted the alternate contention of the assessee-company and held that the assessee is entitled for corresponding deduction from the total turnover, too. This issue was accordingly decided in favour of the assessee.

9. The assessee is aggrieved by the additions sustained by the CIT(A) on account of ALP adjustment and disallowance of compensation payment. On the other hand, the revenue is aggrieved on the direction of the CIT(A) to reduce lease line charges from the total turnover of the assessee-company. Therefore, these cross appeals before us.

10. In the appeal filed by the assessee-company, therefore, two issues are agitated. The first and predominant issue is the question and quantum of ALP adjustment arising out of transfer pricing. The second issue is regarding the nature of compensation paid by the assessee on termination of agreement relating to the purchase of property. Therefore, the appeal filed by the assessee is substantially a transfer pricing appeal.

11. The grounds raised by the assessee-company are extracted below :

"(i )The learned CIT(A) has erred, in law, and in facts, in confirming the assessment/computation of total income made by the Assessing Officer (AO) of Rs. 12,39,08,030. The appellant craves that the income assessed be deleted.

(ii )The learned CIT(A) has erred, in law, and in facts, in confirming the total net tax payable as computed by the Assessing Officer of Rs. 6,16,18,313. The appellant craves that the tax computed be deleted.

(iii)The entire order is erroneous and bad in law and the demand pursuant to the order to be quashed.

Transfer Pricing

(iv)The learned CIT(A) has erred, in law and in facts, in confirming the order of the TPO/Assessing Officer by holding that the international transaction of software development and consultancy services is not at arm’s length and by holding that the appellant’s net margin on operating cost works out to 5.43 per cent.

(v )The learned CIT(A) has erred in confirming the order of the TPO/Assessing Officer and concluding that the companies identified by the TPO/Assessing Officer are comparable, without proper verification of the same.

(vi)The learned CIT(A) erred in holding that the Assessing Officer was justified in making a reference to the learned TPO. The appellant prays that Assessing Officer has erred, in law by making a reference to the learned Transfer Pricing Officer without meeting the preconditions for such reference under section 92CA of the Act. Based on the facts and circumstances of the case, there was neither necessity nor expediency for such reference as there was no attempt on the part of the appellant to willfully understate the value of its international transaction. Further, no opportunity was provided by the learned Assessing Officer to the appellant before referring the transfer pricing issues to the learned Transfer Pricing Officer.

(vii)The learned CIT(A) erred in confirming that the Assessing Officer was justified in relying on the order of the TPO as he was in consensus with the order. The appellant prays that the same is in violation of principles of natural justice as the Assessing Officer ought to have independently applied his judgment to the order of the TPO with due cognizance to the Appellant’s various rebuttals and ought not to have mechanically accepted the conclusions stated in the TPO’s order.

(viii)The learned CIT(A) has erred, in law, and in facts, in confirming the rejection of the comparable companies identified by the appellant, based on ad hoc factors such as ‘turnover criterion’, ‘functional dissimilarity’, having disregarded the explanations furnished by the appellant in this regard.

(ix)The learned CIT(A) erred, in law and in facts, in confirming that, the approach in determining the arm’s length margin/price based on a new list of comparable companies identified at the time of assessment proceedings is justified. The appellant prays that the same be deleted given that the information was not available to the appellant at the time of complying with the documentation requirement and most of such companies are not comparable to be appellant either on account of functional differences, due to insufficient segment-wise information or other comparability factors.

(x )The learned CIT(A) erred, in law and in facts in confirming that TPO/Assessing Officer was justified in using a turnover filter to identify the new list of comparable companies. The appellant prays that the same be deleted given that there is no rational basis for the use of such filter.

(xi)While the CIT(A) has implicitly accepted the fact that companies with ‘super normal’ profits should not be considered, he has erred in law and in facts, in confirming that the TPO/Assessing Officer was justified in arbitrarily normalizing the net margins earned by such super normal comparable companies with the profits/net margins made by some other company [which the appellant believes for certain other reasons also is not comparable]. The appellant prays that the same be deleted given that there is no rational basis for choice of such net margin and normalization.

(xii)The learned CIT(A) has erred, in law and in facts, in confirming the order of the TPO/Assessing Officer by holding that the manner of computation of arm’s length price undertaken by the TPO/Assessing Officer is justified. The appellant prays that the same be deleted as the learned TPO/Assessing Officer has not given effect to the foreign exchange fluctuation income earned by the appellant in normal course of business and has erred in not excluding certain expenses such as donation etc. while computing the operating costs.

(xiii)The learned CIT(A) has erred, in law and in facts, in confirming the order of the TPO/Assessing Officer by holding that the manner of computation of arm’s length price undertaken by the TPO/Assessing Officer is justified. The appellant prays that the same be deleted as the learned TPO/Assessing Officer has erred in not excluding the compensation charges paid for termination of agreement while computing the appellants margins, which is treated as capital expenditure by the learned TPO/Assessing Officer.

(xiv)The lower authorities erred, in law and in facts, by not taking into consideration certain specified income/expenses in computing the operating margins of the comparable companies.

(xv)The lower authorities have erred in law and in facts in disregarding the adjustments provided by the appellant for working capital and not adjudicating on the matter. Further, the lower authorities have also erred in law and facts by not making suitable adjustments to account for the differences in the risk profile of the comparable companies and the appellant.

(xvi)The learned CIT(A) has erred, in law and in facts, in confirming the computation of arm’s length price undertaken by the TPO/Assessing Officer without considering the lower ± 5 range from the price computed based on arithmetic mean of the net margin of the comparables.

Compensation charges

(xvii)Without prejudice to the ground No. 12, the learned CIT(A) has erred, in law, and in facts, in holding that the compensation charges paid for termination of agreement are capital in nature and, therefore would not be allowed as a deduction for income-tax purposes.

(xviii )The learned CIT(A) has erred, in law, and in facts, in confirming the order of Assessing Officer, by not appreciating the fact that the compensation charges were incurred for the purpose of business and is an allowable business expenditure under section 37(1) of the Act."

12. Per contra, the only issue raised in the appeal filed by the revenue is the question of reducing the total turnover by an amount equal to the amount, by which, the export turnover of the assessee has been reduced. The grounds raised therein are as follows :

(i)The learned CIT(A) has erred in directing the Assessing Officer to exclude the lease line/high speed link charges from the total turnover for the purpose of working out deduction under section 10A.

(ii)For these and other grounds that may be urged at the time of hearing, it is prayed that the order of the CIT(A) insofar as it relates to the above grounds may be reversed and that of the Assessing Officer may be restored.

13. We heard S/Shri Rajan Vora, M.P. Lohia, Chavali Narayan and Ms. Pavithra Shetty, Chartered Accountants for the assessee-company and Smt. Preeti Garg, the Commissioner of Income-tax appearing for the revenue.

14. In assessee’s appeal, the specific grounds 1, 2 and 3 related to general arguments that the assessing authority has erred on facts and in law in determining a positive total income as against the loss reported by the assessee-company. Though these grounds do reflect the ultimate grievances of the assessee, they are not in the nature of specific grounds which call for adjudication. Therefore, these grounds do not require discussion.

15. Ground No. 5 is again general in nature and confined to the issue of transfer pricing. As the assessee has already raised several grounds against the ALP adjustment determined by the TPO, based on various propositions of law and facts, it is not incumbent on us to make any specific finding on this general ground. This ground is, therefore, allowed to take rest.

16. Grounds 6 and 7 relate to the question whether the Assessing Officer is justified in referring the transfer pricing issue to the TPO. It is the case of the assessee-company that the transfer pricing reference was made without affording an opportunity to the assessee.

17. On the above grounds, the learned Chartered Accountant contended that the Assessing Officer has not established any purposive intention on the part of the assessee-company to manipulate its Indian profits for the purpose of tax evasion. According to the learned Chartered Accountant, Transfer Pricing Regulations have been enacted in India to curb tax evasion through the medium of transfer pricing. This intention has been elaborated by the Central Board of Direct Taxes (CBDT) in its Circular No. 14/2001, dated 12-12-2000 [252 ITR (St.) 65]. It is explained in the Circular that the intention of transfer pricing regulations is to prevent shifting out of profits by manipulating price charged or paid in the international transactions thereby evading the country’s tax base. In assessee’s case, it is enjoying the benefit of exemption under section 10A and, therefore, there is no tax liability and the de facto tax rate in India as applicable to the assessee is much lower than the tax rate applicable to its Associate Enterprise in Germany. When this is the situation, it is very apparent that the assessee would not be motivated to manipulate the transfer price to understate its profits. The learned Chartered Accountant has placed heavy reliance on the CBDT Circular No. 14/2001 and on the decision of ITAT, Bangalore Bench in the case of Philips Software Centre (P.) Ltd. v. Asstt. CIT [2008] 26 SOT 226 (Bang.).

18. The learned Chartered Accountant has also assailed one of the findings of the CIT(A) that transfer pricing reference has become necessary in the present case, as the assessee-company is enjoying the benefit of deduction under section 10A. It is the case of the learned Chartered Accountant that the proviso to section 92C(4) provides that the income determined on the basis of ALP adjustment would not be entitled for the benefit under section 10A. It does not mean that application of section 10A to an assessee by itself is a reason to refer the case to the TPO.

19. Smt. Preeti Garg, the learned Commissioner on the other hand contended that it is incumbent upon the Assessing Officer to ensure that the assessee-company has concluded its international transactions at Arm’s Length Price (ALP). In this case, it is more particular to observe that the entire international transactions executed by the assessee-company were with its associate concern in Germany and the entire turnover of the assessee except for nominal domestic turnover was in export sector. Therefore, it was very much necessary on the part of the Assessing Officer to examine the pricing structure of the services rendered by the assessee-company. Even to examine the preliminary question whether there was a motive to evade tax or not, the assessing authority has to first convince himself that the transactions were concluded at ALP. In this case, it was necessary for Assessing Officer to refer the case to TPO, so that a detailed enquiry is made into the whole issue and proper conclusion is arrived at. She, therefore, submitted that the contention advanced by the assessee-company does not stand on merit.

20. We heard both sides in detail and proceed to consider whether the Assessing Officer was justified in referring the ALP to the TPO without affording an opportunity to the assessee-company of being heard.

21. The above preliminary objection raised by the assessee cannot be answered without touching the outline of the law and subject of transfer pricing. In the present law, as it stands under sections 92 to 92F, provisions are relating to the computation of income from international transactions having regard to Arm’s Length Price. This is not a new generation concept, as such. There were procedures under section 42(2) of the Income-tax Act, 1922 authorizing the Assessing Officer to work out reasonable profits out of international transactions, where the parties are related. This enabling provision was again implanted in the Income-tax Act, 1961 in section 92. The said section 92 provided for the method of computing income from transactions with non-residents, in certain cases. The law provided that whenever a business is carried on between a resident and a non-resident and it appears to the Income-tax Officer that, owing close connection between them, the course of business is so arranged that the business transaction between them produce to the resident either no profits or less than the ordinary profits, the Income-tax Officer shall determine the amount of profits, which reasonably be deemed to have been derived therefrom and adopt such amount in the total income of the resident. This section also was provided under Chapter X dealing with special provisions relating to the Avoidance of Tax. Later, on expansion of globalization, the volume of international transactions increased multi-fold creating real problems in examining the profitability of international transactions in different cases, so as to make a legitimate claim on the share of tax attributable to the profits generated within the territorial jurisdiction of the host State. As the transfer pricing mechanism developed into a tool to manipulate the actual profits of resident-assessees, it was necessary to explain the provisions of section 92 in a more elaborate manner. It is how sections 92 to 92F were substituted for section 92 by the Finance Act, 2001 with effect from 1-4-2002. These provisions have again been substituted by the Finance Act, 2002 with effect from 1-4-2002, with which, we are to deal in, as far as the present appeals are concerned. It is to be seen that the substitutions of section 92 have been made for the purpose of standardizing the procedure and practice relating to computation of profits arising out of international transactions between related parties and to make such practice and procedure on par with international convention and practice.

22. If we speak law, it is necessary to understand that even without a specific provision like section 92, it is always possible for the assessing authority to examine every vital and relevant aspect of international transactions between related parties in the course of assessment proceedings. This is because his writ is to compute the correct income of a particular assessment year. This obligation cast on the Assessing Officer is the product of the charging section 3 by which the chargeable income of an assessee has to be computed. Section 3, the charging section is the soul; but the soul alone is not sufficient. One needs limbs and organs. These are the elaborations made under different Chapters and in various sections of the Income-tax Act so that the assessment proceedings are made less arbitrary and less subjective.

23. Consequently, it is easy to understand that determination of ALP is only a statutory procedure available for doing an assessment. It is one of the procedures prescribed by law, so that the Assessing Officer may examine certain vital aspects of income generating points. So, the transfer pricing analysis form part of assessment procedure itself. It is that procedural law which enables the Assessing Officer to refer the question of determination of ALP to the authority, designated as TPO. The ALP referred to the TPO even though very important, is accordingly incidental to the assessment procedure. Therefore, there is no room for the assessee to grieve on this point. It cannot be held that natural justice is denied to the assessee for the reason that the ALP was referred to the TPO without hearing the assessee. The TPO is framing his propositions and conclusions only after hearing the assessee and considering the objections raised by the assessee. Therefore, the right of the assessee to be heard is not violated.

24. The argument of the assessee with reference to section 10A status also needs a mention. It is the case of the assessee that it is enjoying section 10A benefit and no tax is payable on export income, which makes the Indian tax rate more attractive than German tax rate and, therefore, there could be no motive to understate assessee’s income. This argument could be a good logic, but only for those assessment years covered by section 10A benefit. Once the benefit is exhausted, the assessee would be liable for taxation in which case, the German tax rate may be more attractive. If the pricing for the exempted years is accepted without analysis there is every chance that the assessing authority might be estopped, on the doctrine of consistency, from examining the pricing for the subsequent non- exempted years. This is quite uncalled for.

25. The Special Bench of the ITAT, Bangalore in the case of Aztec Software & Technology Services Ltd. v. Asstt. CIT [2007] 294 ITR (AT) 32¹ (Bang.) (SB) has considered the same issue. The larger Bench held that although Chapter X has the title ‘Special provisions relating to Avoidance of Tax.’ and aims at various sections under Chapter X is to check avoidance of tax, diversion of income and funds by non-residents from India, it is not necessary that the Assessing Officer has to demonstrate evidences before reference made to TPO. The larger Bench held that the assessee need not be heard before such reference is made. What is necessary for the reference is some materials to rely on.

26. In the facts and circumstances of the case, we hold that the objections raised by the assessee against the reference made by the Assessing Officer are liable to be rejected.

27. But we like to make one clarification. The CIT(A) has recorded an impression in his order that the reference to the TPO is necessary even otherwise, as the assessee-company was enjoying the benefit of deduction under section 10A. Reliance has been placed on the proviso to section 92C(4). The said proviso states that no deduction under section 10A or section 10AA or section 10B or under Chapter VIA shall be allowed in respect of the amount of income by which, the total income of the assessee is enhanced after computation of income in the light of ALP adjustment. It does not mean that wherever the assessee is entitled for the benefits of deduction under section 10A and others, it is mandatory on the part of the assessing authority to refer the case of ALP to TPO. As far as the matter of referring the ALP to TPO is concerned, proviso to section 92C(4) does not have any statutory role. As far as this legal proposition is concerned, we are in agreement with the learned Chartered Accountant appearing for the assessee.

28. Another preliminary objection raised by the learned Chartered Accountant in the course of hearing is on the question of selecting the Most Appropriate Method and the procedure adopted by the TPO in this case. Initially, the TPO has worked out the ALP on the basis of Man Hour Rate charged by the assessee to its Associated Enterprise. The assessee has charged US$ 15.66 per man hour. As per NASSCOM report, the prevailing billing rate was US$ 18 - US$ 25 per man hour. The assessee explained that the man hour rate computed by the TPO must be weighted by the leave benefits given to the employees. If that factor is also considered, the man hour rate of the assessee-company is worked out to US$ 22.62. This rate was within the range reported by the NASSCOM. Once this was clarified, the TPO left behind the man hour rate method and adopted TNMM, as the most appropriate method for determining the ALP.

29. The argument of the learned Chartered Accountant is that once the TPO has adopted a particular method for comparing the price derivation for the purpose of ALP, it is not open for him thereafter to switch over to another method. It is the contention of the learned Chartered Accountant that the TPO should confine himself to the first method selected by him.

30. Section 92C provides different methods, as most appropriate methods for the purpose of determining the ALP. The methods are :

u Comparison of Uncontrolled Price Method (CUP)

u Resale Price Method (RPM)

u Cost Plus Method (CPM)

u Profit Split Method (PSM)

u Transactional Net Margin Method (TNMM)

u And any other method prescribed by the Board.

31. The above methods are statutorily recognized set of computational tools and they are to be deployed depending on the facts and features of every case. The manner, in which the above method shall be applied, has been prescribed especially in Rule 10C. The procedures so prescribed by the rules are in fact in the nature of statutory guidelines.

32. The selection of one of the methods as most appropriate method in a given case has to be made also by human skill and expertise. It is not possible to prescribe procedure/practice for every occasion. Even in the same industry, it depends on the nature of transactions and circumstances surrounding the transactions. The approach would be different from industry to industry. Therefore, ultimate selection of a method in a particular case may some times be possible, only if all other methods are sufficiently evaluated and excluded. Because of this exclusion process, therefore, shifting from one method to another method in the selection process of the most appropriate method is inherent in a transfer pricing case. In fact, selection of the most appropriate method contemplates a study on the adaptability of other methods as well. We cannot, therefore, accept the argument of the learned Chartered Accountant that once the TPO has selected one method, thereafter, he cannot prefer another one. The TPO has to do the process of selection to ultimately choose one of the methods prescribed under section 92C. The only point is that the TPO should not compound different methods and use multiple approach in determining the ALP. It is necessary for him to zero down on a particular method as the most appropriate method.

33. Therefore, the second objection is also rejected.

34. We are discussing the issues relating to Transfer Pricing. So far, we have considered the general grounds as well as three specific objections raised by the assessee. The first objection is whether the Assessing Officer was justified in referring the transfer price issue to the TPO. This objection has been considered and held against the assessee as discussed in paragraphs 21 to 27 above. The second objection was on the question of selecting the Most Appropriate Method (MAM), with reference to the particular contention that the TPO has to confine himself to the first method considered by him. This objection has also been held against the assessee as discussed in paragraphs 28 to 33 of this order. The third issue was that the assessee had no motive to understate its income, as it was enjoying the benefits of deduction under section 10A. This question has also been answered against the assessee vide paragraph 24 of this order.

35. Now, we may proceed to consider the remaining grounds on the issue of transfer pricing, which mainly relate to the methods adopted by the TPO/Assessing Officer in selecting and omitting the comparables in determining the margin of the assessee-company, the operating costs and normalizing the cases of extreme profits which were adopted for comparison, relevance of other parameters like Function, Assets, Risk (FAR), Capital etc. in scaling the operating margin of comparables, etc.

36. While examining these issues, mainly of facts, it is necessary for us to settle down on certain basic issues. One of the basic issues, thus to be considered at the outset itself is the argument of the assessee that whether, the Assessing Officer/TPO has erred in computing the assessee’s net margin (operating profit) at 5.43 per cent. This issue raised by the assessee is reflected in grounds 4, 12, 13 and 14. These grounds are as follows:

"4. The learned CIT(A) has erred, in law and in facts, in confirming the order of the TPO/Assessing Officer by holding that the international transaction of software development and consultancy services is not on arm’s length and by holding that Appellant’s net margin on operating cost working out to 5.43 per cent.

12. The learned CIT(A) has erred in law and in facts in confirming the order of the TPO/Assessing Officer by holding that manner of computation of arm’s length price undertaken by the TPO/Assessing Officer is justified. The appellant prays that same be deleted as the learned TPO/Assessing Officer has not given effect to the foreign exchange fluctuation income earned by the appellant in normal course of business and has erred in not excluding certain expenses such as donation etc., while computing the operating costs.

13. The learned CIT(A) has erred in law and in facts, in confirming the order of the TPO/Assessing Officer by holding that the manner of computation of arm’s length price undertaken by the TPO/Assessing Officer is justified. The appellant prays that the same be deleted as the learned TPO/Assessing Officer has erred in not excluding the compensation charges paid for termination of agreement while computing the appellant’s margin which is treated as capital expenditure by the learned TPO/Assessing Officer.

14. The lower authorities have erred in law and in facts by not taking into consideration certain specified income/expenses in computing operating margins of the comparable companies."

37. The TPO/Assessing Officer has worked out the net margin at 5.43 per cent. This margin has been worked out on the basis of the following variables :

38. On the other hand, the case of the assessee is that while working out the operating profit, the Assessing Officer/TPO has not excluded extraordinary items from the receipt side and at the same time has included extraordinary and abnormal items in the expenditure. It is the case of the assessee-company that if those items are included/excluded in working out the operating net margin, it would come to 7.15 per cent as detailed in the TP study filed by it.

39. The item, which should have been included in the sales for the purpose of computing the net operating margin is the foreign exchange fluctuation gains. Another item, which is to be included in the operating income, according to the assessee-company is other misc. income constituting income-tax refunds. According to the assessee, such receipts also should be included in operating profits for the purpose of arriving at a Profit Level Indicator (PLI), to make comparison with other selected companies. Another item to be excluded from the expenditure side according to the assessee-company, is the donations. If the above-mentioned items are adjusted as argued by the assessee-company, the net operating margin would be 7.15 per cent as reflected in the TP study made out by the assessee.

40. The assessee had paid a compensation of Rs. 1.05 crores in the previous year relevant to the assessment year under appeal for breach/termination of contract. The assessee had entered into an agreement for the purchase of a property. Later on, the assessee got a better property from a Government agency. In view of the better choice, the assessee terminated the earlier contract. On termination of that contract, the assessee was bound to make a compensation payment of Rs. 1 crore to the other party. The payment of the above compensation attracted 5 per cent service tax also. Accordingly, the assessee paid a total amount of Rs. 1.05 crores as compensation on termination of the earlier property purchase agreement. While working out the operating profits, the Assessing Officer/TPO has not excluded this unusual payment from the expenditure side. This being an extraordinary item, it is the case of the assessee-company that the same should be excluded from computing the operating expenses. If that contention is also accepted, the assessee submits that its operating net margin would be 8.83 per cent.

41. In support of the arguments, the assessee has relied on the following decisions:

1.CIT v. Rachna Udyog [2010] 230 CTR 72 (Bom.)

2.CIT v. Syntel Ltd. [IT Appeal Nos. 1974, 1976 and 1978 of 2009, dated 15-12-2009]

3.CIT v. Woodward Governor India (P.) Ltd. [2007] 294 ITR 451¹ (Delhi)

42. We considered the issue carefully. The foreign exchange fluctuation gains is nothing but an integral part of the sales proceeds of an assessee carrying on export business. This proposition has been time and again considered in cases arising in the context of section 80HHC. The Courts and Tribunals have held that foreign exchange fluctuation gains form part of the sale proceeds of exporter-assessee. Useful reference may be made to the decisions of Bombay High Court in the case of Shah Bros. v. CIT, [2003] 259 ITR 741 ²; that of Gujarat High Court in the case of CIT v. Amba Impex [2006] 282 ITR 144 ³ and that of Mumbai ITAT Spl. Bench in the case of Asstt. CIT v. Prakash L. Shah [2008] 306 ITR (AT) 1⁴. In all the above cases, the dominant question considered was the year of deduction on the accepted proposition that the foreign exchange fluctuation gains computed by an assessee in a relevant previous year should be treated as part of the operating income and thereby it would contribute to the operating margin of the assessee-company. The foreign exchange fluctuations income cannot be excluded from the computation of the operating margin of the assessee-company. This contention of the assessee is accepted.

43. The contention of the assessee that the income-tax refund credited as other misc. income in the accounts of the assessee-company should be included in the operating profits for the purpose of arriving at the Profit Level Indicator (PLI), cannot be accepted. It is for the simple reason that the operating profit of an assessee is computed without considering the income-tax payments as well as income-tax refunds. The question of income-tax liability does not arise in the computation of operating profit. Therefore, either income-tax payments could not be reduced or income-tax refund could be increased in adjusting the operating profit of an assessee. This contention is dismissed.

44. Regarding the donations also, we do not agree with the arguments of the assessee-company. Donations as such, may not be deductible in the normal course of computing the taxable income of an assessee. Because the principle is that donation is not an expenditure, but is an appropriation of funds. At the same time we cannot overlook the fact that donations are regular expenditure incurred by an assessee in the ordinary course of carrying on its business. Therefore, it is not proper to argue that donations must be excluded from the expenditure side. The donations made by the assessee have to be considered as normal business outgoings. This contention also fails.

45. With reference to the arguments of the assessee on the issue of compensation payment of Rs. 1.05 crores, the assessing authority himself has disallowed this item as an item of capital expenditure. The assessee had proposed to purchase a property and an agreement was entered into. As the assessee could acquire a better property on more favourable terms, the earlier proposal was dropped and agreement was terminated. This development resulted in payment of compen- sation. It is not a regular operating expenditure of the assessee. This is a classic example of extraordinary item. Therefore, this amount of Rs. 1.05 crores cannot be treated as part of the operating expendi- ture of the assessee and, therefore, it should be excluded from the computation of operating margin of the assessee. This ground is allowed.

46. To sum up, we find that the assessee’s contentions on two items of adjustments are found justified and accepted; they are, foreign exchange fluctuation gains and the compensation payment. The adjustment sought for by the assessee in respect of income-tax refund and donations are not accepted.

47. As already stated above, the operating margin as per assessee’s TP study is 7.15 per cent. This is subject to adjustment. We have discussed in paragraphs above that if the compensation is excluded from the expenditure side, the operating margin of the assessee works out to 8.83 per cent. At the same time, the effect of income-tax refund and donations would go to reduce the above operating margin but very marginally. The donations booked as expenses under the head ‘administrative cost’ is Rs. 12,95,437. Any how, the effect of these two items will be nominal. But the adjustment has to be done to increase the operative profit to that marginal extent. Therefore, we fix the operating margin of the assessee-company at 8.80 per cent against the rate of 5.43 per cent determined by the Assessing Officer/TPO and 8.83 per cent claimed by the assessee.

48. Overall, the grounds of the assessee relating to the computation of net margin is partly allowed.

49. After discussing the basic issue of operating margin of the assessee-company and determining the same at 8.80 per cent, we now proceed to consider the next basic issue of normalization of margins of companies making super profit which were considered as comparables by the TPO/Assessing Officer.

50. This issue is raised by the assessee in ground No. 11, which reads as follows :

"(xi)While the CIT(A) has implicitly accepted the fact that companies with ‘super normal’ profits should not be considered, he has erred in law and in facts, in confirming that the TPO/Assessing Officer was justified in arbitrarily normalizing the net margins earned by such super normal comparable companies with the profits/net margins made by some other company [which the appellant believes for certain other reasons also is not comparable]. The appellant prays that the same be deleted given that there is no rational basis for choice of such net margin and normalization."

51. It is the case of the assessee that TPO/Assessing Officer while identifying certain companies like M/s. Hinduja TMT Ltd., and Aftek Infosys Ltd., has normalized their net margins with profits made by other companies taken as comparables, for which there is no provision in the Act and Rules. If at all such companies are selected as comparables, adjustments will have to be carried out to exclude the impact of material differences as provided in Rule 10B(1)(c)( iii)/10B(1)(e)( iii). The rules do not provide for normalization of the margins of super profit making companies on an ad hoc basis by comparing the profits of other companies selected as comparables. According to the assessee, the selection of super profit margins and normalizing it on an ad hoc basis have contributed for a higher arithmetical mean margin of the comparables, which has unjustifiably shadowed the margin disclosed by the assessee-company.

52. The assessee has relied on the decision of ITAT Pune Bench delivered in the case of E. Gain Communications (P.) Ltd. v. ITO [2008] 23 SOT 385 and also the decision of ITAT Delhi Bench in the case of Mentor Graphics (Nodia) (P.) Ltd. v. Dy. CIT [2007] 109 ITD 101.

53. We considered the issue. It is to be seen that the assessee-company does not have much open market operations like other independent competitors operating in the market. The assessee is one of the world centers established by its holding company, M/s SAP AG in India to provide R&D and Software Technology Services, almost carrying on, back office operations. The agreement between the assessee and its holding company stipulates the remuneration at cost plus 6 per cent or total wages bill, whichever is higher. Therefore, it is to be seen that the assessee-company, as such, working in Bangalore is having only a limited role in generating what is called ‘commercial profit’ and, therefore, it cannot be compared with other leaders plying in the market. It is also relevant to note that the assessee-company is working in a risk-mitigated environment. When this is the position, TPO/Assessing Officer cannot select extreme cases as comparables to examine the ALP of the assessee-company under TNMM method.

54. The TPO/Assessing Officer has selected M/s. Hinduja TMT Ltd., as one of the comparables. The reported margin of the said company is 111.45 per cent. This is an extreme case of super profit. Likewise, another company selected by the TPO/Assessing Officer as comparable is M/s. Aftek Infosys Ltd. In this case, the margin is 69.70 per cent, which is again very much on the higher side. The TPO/Assessing Officer has normalized their Profit Limit Indicator (PLI) to 31.78 per cent adopting the margin reported in the case of M/s. Infotech Enterprises Ltd. At the same time, the TPO/Assessing Officer has not explained the common thread running through all these four entities to bring out a functional similarity. In these circumstances, it is our considered view that such super profit making companies cannot be considered as comparables in the present case. Therefore, we exclude M/s. Hinduja TMT Ltd. and M/s. Aftek Infosys Ltd. from the list of comparables.

55. The ground raised by the assessee-company on normalization of super profit is accordingly accepted and allowed.

56. The third basic issue to be considered is whether the assessee is entitled to exercise option provided for in the second proviso to section 92C(2) of the Income-tax Act, 1961.

57. This issue is raised by the assessee in ground No. 16, which is extracted below :

"(xvi)The learned CIT(A) has erred, in law and in facts, in confirming the computation of arm’s length price undertaken by the TPO/Assessing Officer without considering the lower ± 5 range from the price computed based on arithmetic mean of the net margin of the comparables."

58. It is the contention of the assessee-company that the said proviso provides that where more than one price is determined by the Most Appropriate Method (MAM), the Arm’s Length Price (ALP) shall be taken to be the arithmetical mean of such prices, or, at the option of the assessee, a price which may vary from the arithmetical mean by an amount not exceeding 5 per cent of such arithmetical mean. It is the case of the assessee that if the price determined is in excess of 5 per cent range, the adjustment should be limited to 5 per cent ±, as the assessee has exercised its option under that proviso. The assessee has placed reliance on the decision of ITAT Delhi Bench in the case of Sony India (P.) Ltd., v. Dy. CIT [2008] 114 ITD 448 which has held that under the TPO regulations in India, an option has been provided to a taxpayer to consider an ALP which may vary from the arithmetical mean an amount not exceeding 5 per cent of such arithmetical mean. This option intends to provide marginal benefit at the choice of the taxpayer. It is the case of the assessee that the revenue’s contention that marginal benefit of 5 per cent from the arithmetical mean is not available in cases, where the price shown by the assessee exceeded 5 per cent of the ALP is not a proper exposition of law. The assessee has also relied on the decision of ITAT, Calcutta Bench in the case of Development Consultants (P.) Ltd. v. Dy. CIT [2008] 23 SOT 455 in support of the above argument.

59. The proviso regarding the marginal relief of 5 per cent contemplated in the computation of ALP has been substituted by the Finance (No. 2) Act, 2009 with effect from 1-10-2009. The said sub-section (2) and the proviso are extracted below :

"(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 arithmetic mean of such prices:

Provided further that if the variation at arm’s length price so determined and price at which the international transaction has actually been undertaken does not exceed five per cent of the latter, the price at which the international transaction has actually been undertaken shall be deemed to be the Arm’s Length Price]."

60. The above proviso has two limbs. The first limb provides for the arithmetical mean of prices, where more than one price is determined as the Most Appropriate Method. This is the only natural remedy where more than once price is determined. The second limb of the proviso is providing a marginal relief of 5 per cent to the assessee in computing the ALP applicable to it. If the difference between the ALP determined on averaging the prices and the ALP disclosed by the assessee does not exceed 5 per cent, then the benefit of doubt is given to the assessee by way of marginal relief and the ALP disclosed by the assessee itself has to be taken as ALP for assessment. In other words, if the ALP determined on the basis of Most Appropriate Method does not exceed 5 per cent of the ALP disclosed by the assessee, the ALP determined under the Most Appropriate Method has to be ignored. The deviation may be on either side; 5 per cent more or 5 per cent less. If the average mean ALP determined on the basis of the Most Appropriate Method is more than ALP disclosed by the assessee by a factor exceeding 5 per cent, then the ALP determined on the basis of the Most Appropriate Method shall be the ALP to be adopted for the purpose of assessment. In that case, the ALP disclosed by the assessee will not be accepted.

61. The CBDT in its Circular No. 5/2010 dated 3-6-2010 has clarified that this new provisos are effective from 1-4-2009 onwards. In fact these provisos have been brought into the Act by Finance (No. 2) Act, 2009. So, it will be applicable to the assessment year 2009-10 and onwards.

62. In the present case, the assessment year is 2003-04. Therefore, the amended provisos as explained above are not applicable to the present case in hand. The proviso applicable to the present case is the one which stood before the substitution brought in by the Finance (No. 2) Act, 2009 with effect from 1-10-2009. The earlier proviso is extracted below:

"[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, or, at the option of the assessee, a price which may vary from the arithmetical mean by an amount not exceeding five per cent of such arithmetical mean.]"

63. The first limb of the old proviso and the first limb of the present proviso is regarding arriving at the arithmetical mean which is the same. There is no change with regard to that. The change is with reference to the second limb. The old proviso says that at the option of the assessee, the assessee may adopt a price different from the arithmetical mean by an amount not exceeding 5 per cent of such arithmetical mean i.e., the assessee has an option to claim the taxpayer’s marginal relief at 5 per cent with reference to the arithmetical mean irrespective of the range of actual deviation between the margin disclosed by the assessee and the Average Mean Margin. Therefore, in effect, this marginal relief takes the character of a standard deduction of 5 per cent. For e.g. in a case, average mean of the ALP determined by TPO/Assessing Officer is 20 per cent and that one disclosed by the assessee is 10 per cent. The assessee will get a standard deduction of 5 per cent and the assessee’s ALP will be increased to 15 per cent and thereafter the difference of 5 per cent between 20 per cent and 15 per cent alone shall be added as ALP adjustment. This is the theme of the old proviso. But under the newly substituted proviso, the marginal relief of 5 per cent will not Act as standard deduction. If the price determined by the Average Mean Price is 20 per cent and that of the assessee is 10 per cent, then the difference of 10 per cent is more than 5 per cent and, therefore, the assessee will not get the marginal relief and the entire difference of 10 per cent will be added as ALP adjustment. If the ALP determined by TPO/Assessing Officer is 15 per cent and that of the assessee is 11 per cent, the difference of 4 per cent is less than 5 per cent and in that case, the rate disclosed by the assessee at 11 per cent shall be taken as ALP. This is the position after the amendment.

64. In view of the above discussion, we find that second limb of the proviso to section 92C(2) gives an option to the assessee to claim a marginal variance of 5 per cent as standard deduction. This ground of the assessee is accepted and we hold that this benefit of deduction of 5 per cent has to be given to the assessee, if the circumstances, so warrant.

65. We have considered all the three basic issues mentioned in paragraph 36. All the issues have been decided by and large in favour of the assessee. Inasmuch as regarding operating margin of the assessee-company, we have determined the same at 8.80 per cent as against the rate of 5.43 per cent determined by the TPO/Assessing Officer. We have held against the ‘normalization exercise’ adopted by the TPO/Assessing Officer and excluded M/s. Hinduja TMT Ltd. and M/s. Aftek Infosys from the list of comparables. We have also held that the assessee is entitled for 5 per cent deduction by way of marginal relief as provided in the second limb of proviso to section 92C(2).

66. In the light of the above, we proceed finally to determine the arguments of the assessee-company with regard to the determination of ALP. The contentions of the learned Chartered Accountants are summarized below :

"1. The assessee has determined the Transactional Net Margin Method (TNMM) as the Most Appropriate Method (MAM) to work out the ALP, which is based on the Function, Asset and Risks analysis (FAR). The analysis has been made on the available data from two sources namely prowess and capitaline 2000 and the National Association of Software Companies (NASSCOM) website. As the information for the financial year 2002-03 was not available, the information available to the financial year 2001-02 have been considered for determining arm’s length price (ALP).

2. From the above sources certain companies were excluded from the list of comparables for the reasons that sufficient functional data not available; that descriptions are insufficient; different functions are carried out; that the companies not have sufficient foreign exchange earned; that current business operations are inactive, their substantial transactions were with related parties; that making persistent operating loss and duplicating data base under different names.

3. On the basis of the study made on the 22 comparables selected by the assessee the arithmetic mean of the margin has been worked out. The margin worked out as per the assessee is 7.15 per cent. which fell within (+) or (-) 5 per cent variance from the average ALP of the comparable companies. Therefore, it is apparent that the price charged by the assessee in respect of the international transactions was at arm’s length price as per the transfer pricing regulations.

4. The TPO has arbitrarily adopted a filtering process by which he has excluded all other companies having turnover outside the range of Rs. 50 crores to 150 crores. The TPO has virtually replaced the list of comparables with a new list comprising of 8 companies. The arithmetical mean of the margin, as per that list of comparables works out to 22.24 per cent.

5. The TPO has worked out the operating net margin of the assessee at 5.43 per cent as against 7.5 per cent reflected in the assessee’s accounts and has worked out the ALP adjustment being the difference between 22.24 per cent and 5.43 per cent."

67. The relevant grounds raised by the assessee in this regard are extracted below :

"8. The learned CIT(A) has erred, in law, and in facts, in confirming the rejection of the comparable companies identified by the appellant, based on ad hoc factors such as ‘turnover criterion’, ‘functional dissimilarity’, having disregarded the explanations furnished by the appellant in this regard.

9. The learned CIT(A) erred, in law and in facts, in confirming that, the approach in determining the arm’s length margin/price based on a new list of comparable companies identified at the time of assessment proceedings is justified. The appellant prays that the same be deleted given that the information was not available to the appellant at the time of complying with the documentation requirement and most of such companies are not comparable to be appellant either on account of functional difference, due to insufficient segment-wise information or other comparability factors.

10. The learned CIT(A) erred, in law and in facts in confirming that TPO/Assessing Officer was justified in using a turnover filter to identify the new list of comparable companies. The Appellant prays that the same be deleted given that there is no rational basis for the use of such filter.

15. The lower authorities have erred in law and in facts in disregarding the adjustments provided by the appellant for working capital and not adjudicating on the matter. Further, the lower authorities have also erred in law and facts by not making suitable adjustments to account for the differences in the risk profile of the comparable companies and the appellant."

68. In the light of the above premises and grounds, the learned Chartered Accountant further argued, that :

"1. The TPO can reject the comparables in TP study, only if the comparables are insufficient or deficient. A mere deviation in the turnover of comparables does not alone qualify as a reason sufficient to reject the functional comparables of the assessee. Reliance was placed on the decision of ITAT Delhi Bench in the case of Mentor Graphics (P.) Ltd., v Dy. CIT, 109 ITD 101.

2. The TPO has adopted the turnover filter without conducting a proper Function, Asset and Risk analysis (FAR). This made the selection process of comparables of the TPO arbitrary. The ITAT, Pune Bench in the case of E. Gain Communications (P.) Ltd. v. ITO, ( 23 SOT 385 ), has held that a proper analysis is to be undertaken, even where turnover filter has been used.

3. The Assessing authority has selected 8 comparables. Out of the said 8 companies identified by the TPO, five companies are not comparable for the reason of lack of segmental information, functional differences and segment related party transactions. In the case of Aftek Infosys Ltd., the profit is abnormally high. M/s Geometric Software Selection Co. Ltd., a case considered by the TPO has different functions compared to the assessee company. M/s. Hinduja TMT Ltd., is again a case of supernormal profit and also functionally different. M/s. Infotech Enterprises Ltd. operated in different segments including engineering services. M/s. Visual Soft Technologies Ltd. is also not acceptable as segmental information is not available and also the companies are engaged in ITES-BPO services etc.

4. If the above five companies are excluded from the list of TPO, there are only three comparables remaining. They are, M/s. Kshema Technologies Ltd., M/s. R.S. Software Pvt. Ltd. and Zylog System Pvt. Ltd. The arithmetic mean of the above comparables is 9.39 per cent. With the range of (+) or (-) 5 per cent, the value comes to 14.86 per cent and 3.92 per cent. Even the net margin erroneously worked out by the TPO at 5.43 per cent itself is within the range and, therefore, the transfer pricing adopted by the assessee-company should be accepted as the ALP."

69. The learned CA also argued at length on the need for making working capital and risk adjustment in respect of the comparables, mainly for the reason that the assessee is operating in a ‘risk mitigated environment’ and, therefore, operating profit will be less, when compared to companies, who assumes high amount of functional risks. In support of the elaborate arguments of the learned CA on the matters of these adjustments on the basis of Function, Asset and Risk analysis (FAR) capital adjustment, risk adjustment, specialization etc., reliance has been placed on the following Tribunal decisions:

u Mentor Graphics Nodia (P.) Ltd. (supra)

u Philiphs Software Centre (P.) Ltd. (supra)

u Skoda Auto India (P.) Ltd. v. Asstt. CIT [2009] 30 SOT 319 (Pune)

u Quark Systems (P.) Ltd. v. Dy. CIT [2010] 38 SOT 307 (Chd.) (SB)

70. In conclusion, the learned Chartered Accountant argued that the TPO has selected the comparables to work out the arithmetical mean of operating margin without applying his mind on crucial factors like working capital, Adjustment, Risk Adjustment, Adjustment for R&D Expansion and Growth, difference in risk profile and difference in accounting policies etc.

71. The learned Commissioner on the other hand explained that all these matters have been discussed by the CIT(A) in very detail in his order and all the discussions are supported by exhaustive analysis made by the TPO and, therefore, it is not necessary to repeat them again. She submitted that the TPO has pointed out specific and valid reasons to reject the list of comparables relied on by the assessee-company, as many of the comparables do not conform to normal and acceptable sample size. The assessee-company itself has not undertaken any detailed analysis on the basis of various parameters highlighted by the learned Chartered Accountant. The TPO on the other hand, sourced the details of such comparables which are most appropriate in the line of activities carried on by the assessee-company. She explained that many of the propositions highlighted by the learned CA, do not in fact go to reduce the operational margin of the assessee-company as it is working in a high technological area with a towering command both in providing products and services and in determining competitive prices in international markets. Therefore, she submitted that the average rate of margin determined by the TPO is a proper and just rate for working out the arm’s length price of the international transactions carried out by the assessee during the previous year relevant to the assessment year under appeal.

72. We heard both sides in detail and considered the issue very carefully.

73. The list of 22 comparables and the margins selected by the assessee-company for the TP study is the one below :

74. Likewise, the list of eight comparables and the margins selected by the TPO/Assessing Officer is also given below :

75. The assessee has elaborated its contentions and arguments against adopting five of the comparables selected by the TPO/Assessing Officer. Those, comparables severely objected to by the assessee-company are the following :

76. In the case of M/s. Geometric Software Solution, the case of the assessee-company is that the functions of the assessee-company and that company are different and segmental break up/information in the case of that company is not available. On the basis of these explanations, we accept the contention of the assessee that M/s. Geomatric Software Co. must be excluded from the list of comparables adopted by the TPO/Assessing Officer.

77. In respect of M/s. Hinduja TMT and M/s. Aftek Infosys Ltd., the reason pointed out by the assessee-company to keep them away is that they have disclosed super normal profit, which make these companies un-comparable to normal situations. It was necessitated for the TPO/Assessing Officer to normalize the Profit Level Indicator (PLI) by adopting 31.78 per cent of the result reflected in the case of M/s. Infotech Enterprises. The selection of normalization factor also was on an ad hoc basis. We find force in the arguments of the assessee. Only comparables can be compared. Extreme cases should be avoided while making a comparative study of analogous cases. Therefore, we hold that M/s. Hinduja TMT Ltd. and Aftec Infosys Ltd. must be excluded from the list of comparables adopted by the TPO/Assessing Officer. In the case of M/s. Infotech Enterprises again, the assessee-company explained that the functions are different and the said company operates in three segments GIS services, engineering services and software development services. It is also the case of the assessee that the turnover of M/s. Infotech Enterprises from Software Development Enterprises was less than 50 crores. If we remember the filtering of turnover adopted by the TPO/Assessing Officer, it is justifiable to accept this contention of the assessee. As a reasonable approach, M/s. Infotech Enterprises also should be excluded from the said list.

78. In the case of M/s. Visual Soft Technologies Ltd., it mainly earns income from ITES/BPO services and may not be a safe comparable in the present case. Therefore, the said comparable M/s. Visual Soft Technologies is also excluded from the said list of TPO/Assessing Officer.

79. Against the eight comparables listed by the TPO/Assessing Officer, we have accepted the contentions of the assessee-company and have excluded five of them. The remaining three comparables are the following:

80. The case of the assessee-company is that these three companies are good samples and the arithmetic mean of their margins works out to 9.39 per cent. Even if the margin adopted by the TPO/Assessing Officer at 5.43 per cent is accepted for a moment, by virtue of the option exercised by the assessee in the light of the proviso to section 92C(2), the margin range would be within 3.92 per cent to 14.86 per cent and the margin of the assessee falls within that range. Therefore, it is to be accepted.

81. The argument of the assessee-company cannot be accepted as such, for various reasons. First of all, the comparables available in the revised list of TPO/Assessing Officer is only three. Three comparables are not a reliable sample size. Secondly, we are not inclined to include the case of M/s. R.S Software Pvt. Ltd., in the list of comparables as it has shown a negative margin of -16.33 per cent. The argument of the assessee-company was that the assessee is functioning in a risk mitigated environment which has been by and large accepted by us in our discussion already made in paragraphs above. The assessee-company is not running an apparent amount of risk in carrying on its business in India. It does not have the problem of marketing. It does not have the problem of working capital to a great extent. It is working in a safe harbour. So also, the agreement entered into by the assessee-company with its German Associate concern has provided for remuneration at the rate of cost plus 6 per cent or 1.5 times of the total wages bill, whereby a positive working result has been ensured. The comparables showing negative margins in the list adopted by the TPO/Assessing Officer and the list relied on by the assessee-company are in fact having different business dynamics. We have excluded the cases of M/s. Hinduja TMT Ltd. and M/s. Aftek Infotec Ltd. from the list of TPO/Assessing Officer on the ground that their margins are showing abnormally high returns. Such extremes cannot be the basis of comparison. If such extremes are adopted, the sample value will be skewed very high which will ultimately impair the credibility of the statistical result. It is for the above reason that we have excluded the extreme profit margin cases. Extreme margins do not mean abnormally high profits alone. They include negative results as well. Because of these compelling reasons stated above, we hold that the case of M/s. R.S Software Pvt. Ltd. having a negative margin of -16.33 cannot be considered as comparable.

82. Ultimately, we zero down the list of TPO/Assessing Officer with two comparables :

These comparables will be considered in working out the ALP.

83. Now coming to the list relied on by the assessee-company, we find that the principle applied in downsizing the list of comparables adopted by the TPO/Assessing Officer is applicable to the list of comparables relied on by the assessee-company, as well. Out of the 22 comparables listed by the assessee-company, four comparables have shown negative margins. They are the following :

84. Out of the above four comparables, the case of M/s. Pyxis Technology Selection Ltd. is not only a case of negative return but a case of extreme rate. As has been done in the case of the list of TPO/Assessing Officer, we are excluding these four comparables from the list. These negative margins will not be considered for working the arithmetic mean of margins of the comparables.

85. At the cost of repetition, we have to say that extreme cases should not be included in samples and extreme comparables mean not only the positive higher side but also the lower side. In the list of 22 comparables, many of them are having very low margin rate, not only less than 10 or 5, even below that. We have already considered that the agreement entered into by the assessee with its German Associate concern has contemplated a compensation of cost plus 6 per cent or 1.5 times of the total wages bill, whichever is higher. This point we have to consider in the light of the fact that the assessee is working in a risk mitigated environment. That is why we have agreed with the argument of the assessee-company that there may not be extreme profits in the case of the assessee. When extremes are excluded from the samples, all sorts of extremes should be avoided. Otherwise, samples selected for comparative study may not be representative. Therefore, we are inclined to exclude those comparables having very low margin. Then what should be the cut of rate? The assessee has agreed for a working contract of cost + 6 per cent. Therefore, as a reasonable Profit Level Indicator (PLI), we hold that all the comparables, having margin less than 6 per cent have to be excluded from the list relied on by the assessee. Accordingly, the following comparables are excluded from the assessee’s list:

86. We have so far excluded two comparables of negative margin and six comparables of very low margin, totalling to eight. The exclusions are made not only for the specific reasons stated above, but also for the reason that on the study of the whole scenario, we find that the Function, Asset and Risk analysis (FAR) also does not make out compatibility for comparison.

87. While recasting the comparables list of the TPO/Assessing Officer, we have excluded the case of Infotec Enterprises Ltd. having a margin of 31.78 per cent on the ground that the said company is operating in a functional by different domain. The said reason is applicable to the same comparable included in the assessee’s list, as well.

88. M/s. Infotech Enterprises with a margin of 15.76 per cent is seen included in the list of the assessee and it is excluded.

89. That reasoning of extremely high profits should apply to the comparables adopted by the assessee-company also. The assessee has included M/s. Bodhtree Consulting Ltd. with a margin of 72.39 in its list of comparables. In the case of the list of the TPO/Assessing Officer, M/s. Aftek Infosys Ltd. is excluded on the ground of abnormally high profit of 69.70 per cent. The profit margin of M/s. Bodhtree Consulting Ltd. is much higher at 72.39 per cent. If this is not excluded from the list of the assessee, we will be doing injustice to the assessee-company so also we will be adopting extreme values, which will skew the result of the comparative analysis. Accordingly, the comparable case of M/s. Bodhtree Consulting Ltd. with a margin of 72.39 per cent is also excluded.

90. Altogether, we have excluded 12 comparables from the list relied on by the assessee-company.The balance 10 comparables are adopted to work out the arithmetic mean. The 10 comparables are the following :

91. To summarize the above discussion and to conclude the selection process of comparables, we state that we have adopted two cases from the list prepared by the TPO/Assessing Officer and 10 comparables from the list relied on by the assessee-company. The arithmetic mean will be worked out on the basis of the combined list of both TPO/Assessing Officer and the assessee-company, comprising 12 comparables.

92. The necessary working is made out below :

93. As computed above, the arithmetic mean to work out the ALP is 20.57 per cent.

94. In paragraph 47, we have determined the operating margin of the assessee-company at 8.80 per cent. We have also accepted the contention of the assessee that it is entitled for 5 per cent standard deduction in view of the proviso to section 92C(2), as it is stood for the assessment year 2003-04. When that benefit of 5 per cent is given to the assessee, its operating margin for the purpose of determining the ALP will be bloated to 13.80 per cent. The arithmetic mean worked out by the Tribunal on the basis of the shortlisted comparables is 20.57 per cent

95. Accordingly, we find that the international transactions of the assessee-company have not been concluded at Arm’s Length Price (ALP).

96. The TPO/Assessing Officer/CIT(A) has adopted arithmetic mean at 22.24 per cent and adopted assessee’s operating margin at 5.43 per cent. Accordingly, they have made an addition of Rs. 11,42,86,466 being the additional taxable income by way of operating profit corresponding to the differential margin of 16.81 per cent. The Tribunal has now revised the arithmetic mean to 20.57 per cent and has adopted assessee’s bloated margin at 13.80 per cent. The revised differential margin is 6.77 per cent as against 16.81 per cent determined by the lower authorities.

97. In the light of the above values and variables, the assessing authority has to work out the revised amount of additional income. The Assessing Authority will first compute the operating revenue and operating cost after adjusting for the four items mentioned below :

u Foreign Exchange Fluctuation gains to be added to operating revenue.

u Income-tax refund to be excluded from the operating revenue.

u Donations to be added to the operating cost.

u Compensation to be excluded from the operating cost.

98. The assessing authority will further find out the operating profits at assessee’s rate of 13.80 per cent and the operating profits at the arithmetic mean rate of 20.57 per cent on the basis of the revised revenue and cost computed in paragraph above. The differential amount shall be the addition to be made in term of the ALP adjustment. This amount will be corresponding to the differential operating margin of 6.77 per cent.

99. The grounds raised by the assessee in the matter of transfer pricing, are thus partly successful. The Assessing Authority is directed to modify the ALP adjustment addition accordingly.

100. Next we will consider the issue of the disallowance of Rs. 1.05 crores made by the assessing authority.

101. The assessee had entered into an agreement for the purchase of a property. Before closing the said agreement, the assessee had again an occasion to secure another property at more favourable terms provided by a Government agency. The assessee opted for the latter and terminated the earlier agreement. In terms of the agreement, the assessee was liable to pay a compensation of Rs. 1 crore to the other party. This payment further attracted service tax at the rate of 5 per cent amounting to Rs. 5 lakhs. Accordingly, in discharging its obligation, the assessee had paid Rs. 1.05 crores by way of compensation in the previous year relevant to the assessment year under appeal. The assessee-company claimed this payment as an item of deductible expenditure. The main plank of the argument of the assessee is that the assessee had not acquired any asset or any benefit of enduring nature and the compensation was paid in the ordinary course of business and, therefore, it should be treated as revenue expenditure.

102. The case of the revenue is that the compensation was paid not for running the business activities of the assessee but for establishing capital infrastructural facilities to carry on the business and, therefore, the payment made by the assessee-company would be in the nature of capital payment.

103. We considered the matter in detail. It is true that the assessee has not acquired any tangible asset or an enduring benefit. But, we have to see that the assessee has freed itself from a binding contractual liability. It has discharged its liability by making payment of compensation. Therefore, the question is whether the liability was created for the purpose of carrying on the business in the normal course or for the purpose of establishing the business itself. The assessee was contemplating the purchase of the property for establishing infrastructural facilities for business. Any expenditure incurred in that way would be in the nature of capital expenditure. The payment has not been made for running the business carried on by the assessee in the normal course. So it is not possible to hold that the payment was in the nature of revenue expenditure. While dealing with the transfer pricing issue, particularly while re-computing the profit margin attributable to assessee’s business, we have held that the payment is an extraordinary item and has to be excluded from the expenditure side to work out the operating profit of the assessee. This payment is not an operational expenditure. It is a different matter that the assessee has not acquired any tangible asset or any enduring benefit. It is not relevant how the assessee is going to account it; either as a capital loss or as part of the project cost itself. The fact is that the payment was made by the assessee-company to discharge a capital liability and not a revenue liability.

104. Therefore, we hold that the lower authorities have rightly disallowed the payment of Rs. 1.05 crores and denied the deduction to the assessee-company.This issue is decided against the assessee.

105. The appeal filed by the assessee is partly successful.

106. Next, we will consider the appeal filed by the revenue in ITA No. 418/Bang/2008.

107. As already stated, the only ground raised by the revenue in its appeal is that the CIT(A) has erred in directing the Assessing Officer to exclude the lease line/high speed link charges from the total turnover for the purpose of working out the deduction under section 10A. It is the contention of the assessee-company that in the absence of specific guideline under section 10A, ‘total turnover should be constituted in the same manner as export turnover is defined’. Since the total turnover is only the aggregate of the domestic and export turnover, it naturally follows that items of expense incurred in foreign exchange and to the extent attributable to the delivery of computer software out of India which have been excluded from ‘export turnover’ cannot be included in the total turnover, as well.

108. The above issue has been succinctly considered by ITAT, Chennai, Spl. Bench in the case of ITO v. SAK Soft Ltd. [2009] 313 (AT) 353¹. Highlighting the principle of parity, the Spl. Bench held that the scheme of sections 80HHC and 80HHE has to be considered analogous to the scheme of section 10B and, therefore, the adjustment made in the export turnover should be reflected in the total turnover as well.

109. In the facts and circumstances of the case, we find that the order of the CIT(A) on this issue is just and proper and the ground raised by the revenue is liable to be dismissed.

110. The revenue appeal fails.

111. In result, the appeal filed by the assessee is partly allowed and appeal filed by the revenue is dismissed.