ORDER

Vimal Gandhi, President. - This appeal by the Taxpayer E-Gain Communication Pvt. Ltd., a non-resident company, is directed against the order of the ld. Commissioner of Income-tax (Appeals) ['CIT(A) ' in short], confirming addition of Rs. 1,08,62,537 on account of adjustment in the arm's length price under the provisions of section 92CA(3) of the Act for services rendered by the taxpayer to its parent company in USA.

2. The assessee company is engaged in the business of software product development and is 100 per cent EOU unit approved by Software Technology Park of India under STPI Scheme. It is also taken as leading provider of customer service and contact centre software based on integrated communication platform. The taxpayer has further claimed exemption under section 10A of the Income-tax Act. As per the audited accounts filed by the taxpayer, it has shown the total export turnover of Rs. 10,25,68,917 from which it derived profit of Rs. 46,95,254.

3. The Assessing Officer, after noticing the details of transactions of the taxpayer with its associated concerns, referred the case to the Transfer Pricing Officer (TPO) for computation of arm's length price as per his letter dated 5-6-2006. The TPO, on examination of Form 3CEB i.e., the audit report filed by the taxpayer, found that the taxpayer had claimed that the transactions with its associated concern were carried at arm's length and had relied on TNMM in support of its claim as under :

4. The Transfer Pricing Officer further found that the taxpayer had claimed net profit margin on cost at 5.16 per cent against average profit of 16.12 per cent on similar uncontrolled transactions carried by independent concerns being, similarly computed.

5. The comparable enterprises taken into account for applying Transactional Net Margin Method (TNMM) and Profit Before Income Tax (PBIT) with reference to Total Turnover (TO) and total expenses was taken at 13.29 per cent and 16.12 per cent as per chart below :—

6. In the light of the above detail, Transfer Pricing Officer wanted to make adjustment and, therefore, issued a show-cause notice to the taxpayer. The reply of the taxpayer is noted by the TPO as under.—

(a) E-Gain US pays to the taxpayer an assured income. Therefore, the taxpayer has kept cost plus 5 per cent mark as consideration for transfer to its parent company.
(b) The taxpayer has earned handsome GP of 31.92 per cent on sales.
(c) Taxpayer's operations constitute only 11.26 per cent of US AEs business.

7. The Assessing Officer was of the view that the above points raised by the taxpayer did not answer the low margin of profit charged by it from its associated concern. In fact, the taxpayer had itself revised upward the markup in subsequent years in its dealings with the parent company. The TPO, therefore, made adjustment of Rs. 1,08,62,537 after considering benefits of margin of 5 per cent permissible under proviso to section 92C of the Income-tax Act with the following calculations :—

8. Thus, ALP price of sale of software services by the taxpayer to its AE was taken at Rs. 11,34,31,454. However, the taxpayer has sold above services to its AE for Rs. 10,25,68,917 only and accordingly if -5 per cent is taken into consideration, ALP price is Rs. 10,77,59,88. Thus, the taxpayer does not come within 5.1 margin and, therefore, benefit of above provision was not allowed to the taxpayer. The total addition was worked out at Rs. 1,08,62,537 (Rs. 11,34,31,454 - 10,25,68,917) . The order of TPO is very brief without much elaboration.

9. The aforesaid order of the Transfer Pricing Officer was adopted by the Assessing Officer and assessment was made under section 143(3) of the Income-tax Act.

10. The taxpayer, being aggrieved, impugned the order of the Assessing Officer, particularly above adjustment under the transfer pricing, in appeal before the CIT(A) . It was submitted that 263 software companies were taken into account in the transfer pricing report submitted by the taxpayer to the TPO. After analysis, 54 companies were selected from the public domain. The basis of rejection of other companies through screening was also furnished to ld. CIT(A) . The arithmetic mean of total PBIT over income of 54 companies was worked out at 3.86 per cent against similar mean profit of the taxpayer at 4.76 per cent. It was accordingly claimed that the transactions by the taxpayer were carried with associated concern at Arm's Length Price.

11. The ld. representative of the taxpayer accordingly submitted that in 20 companies taken into consideration by the TPO with turnover ranging from Rs. 8.29 crore to Rs. 360.61 crore as against the turnover of Rs. 10.25 crore of the taxpayer was erroneous. It was accordingly submitted that companies taken into consideration by TPO were not comparable. As against the above, the taxpayer had worked out the arithmetic mean of profit of comparable companies at 9.79 per cent which fell within the margin of Arm's Length Price.

12. It was further submitted by the taxpayer that the data used by the TPO in certain cases indicated that profit before tax (PBIT) was much more than the difference between total turnover and total expenditure. This definitely indicated that those entities (companies) were having income from 'other sources' than the business of software development. The taxpayer does not have any income from any other source. In this connection, the attention of the ld. CIT(A) was specifically drawn to profits and turnover of WTI Advanced Technology Ltd. It was accordingly contended that the above company could not be taken as comparable for determining ALP. The taxpayer also emphasized the fact that it was entitled to exemption under section 10A of the Income-tax Act and, therefore, had no motive to charge less than ALP from its associated concern. The taxpayer also pointed out Ural its associated concern in USA had suffered huge losses and could not afford to pay more than cost +5 per cent benchmark for services rendered by the taxpayer.

13. The determination of net margin ratio with cost at an average figure of 16.12 per cent of comparable entities was thus challenged on the following grounds :—

(i) The TPO was in error in selecting comparable companies with turnover ranged from Rs. 8.29 crore to Rs. 364.61 crore while the taxpayer's turnover was Rs. 10.25 crore only. Thus, the basis adopted by TPO was not right.
(ii) Some of the selected companies had shown abnormally high profit margin and were thus not comparable. Specifically, this objection was taken in relation to comparable at Sl. Nos. 7, 14, 17 and 19 shown in TPO's report.
(iii) The TPO further erroneously took into account companies showing high margin of profit of 30 per cent and more listed at Sl. Nos. 7, 16, 17 and 19 of the chart referred to above.

14. The taxpayer further look objection that some companies taken as comparable had income from other sources, quite dissimilar to the income of software shown by the taxpayer. The non-business income could not be taken into account in working Arm's Length Price.

15. The taxpayer after taking into account companies showing turnover ranging between Rs. 8.29 crore to Rs. 18.29 crore, out of companies taken by TPO worked out average profit of such companies at 17.83 per cent and filed the details with the ld. CIT(A) . If an item of abnormal profit i.e., at Sl. No. 19 was ignored, the resultant profit would work out to only 10.45 per cent, the taxpayer further claimed.

16. The taxpayer accordingly claimed that even from the information gathered and used by the TPO, it was evident that international transact- tion carried by the taxpayer were at arm's length, and, therefore, adjustments made were without any justification.

17. The Ld. CIT(A) , after considering relevant submission of the parties and after reproducing the chart and basis of adjustment of Rs. 1,08,62,537 by the TPO confirmed the adjustment with the following observations :—

"2.4 I have considered the submission of the appellant and perused material on record. The appellant has computed the sale price by adding 5 per cent mark up over the total expenditure. The issue to be considered is whether the addition of 5 per cent over the total expenditure may be said to result in sale price which can be said to be at arm's length price. After taking into account the normal margin in this line of business. I am of the considered view - that there cannot be any doubt that the assessee by keeping cost + 5 per cent mark up for determining the sale price has not computed the price of international transaction at arm's length. It is common place that profit in this line of business is much higher. If income in respect of companies where turnover is Rs. 5 crore to Rs. 25 crore is taken into account. PBT/TE as computed in chart 1 at page No. 3 of the paper book comes to 25.52 per cent. In this regard, relevant figures are as under :—

This is much higher than what is worked out by the Assessing Officer.

The submission of the appellant that 5 per cent margin has been kept because the assessee gets an assured income does not answer the low margin of the appellant. As is noted by the Assessing Officer, in fact the appellant itself has upwardly revised the margin in subsequent year. Be that as it may, on facts of the case, it is held that the Transfer Pricing Officer chose correct sample for re-computing Arm's Length Price of international transactions and adjustment of Rs. 1,08,62,537 made by the Assessing Officer is in accordance with law and for justified reasons and does not call for any interference. Ground Nos. 1 to 3 of appeal are held to have no merit and they fail."

18. The taxpayer, being aggrieved, has brought the issue in appeal before the Appellate Tribunal. Shri Ostwal, learned representative of the taxpayer reiterated that the taxpayer was a 100 per cent EOU. It had specific customers and had supplied software to its parent company in US as per specific requirement of the US parent company. It was argued that the taxpayer company was set up on 7-8-1999. The US entity was set up two years earlier. All risk profiles under the agreements were/are the responsibility of the parent company. Risk involved was credit risk, marketing risk, recovery risk, inventory risk, warranty risk, foreign exchange fluctuation risk or post sale risk. Shri Ostwal further stated that the payment by the tax payer was received by the taxpayer as per agreement with the parent company e-Gain Communication available at pages 1 to 8 of the paper book. The agreement provided for services and scope of work as under :—

"1. Services and scope of work :—

1.1 Services : Subject to the provisions of this Agreement, EC agrees to accept from ECPL & ECPL agrees to provide to EC, software development services, to design, develop, create, maintain and finetune and produce a computer software or to further develop or change an existing software ('Development Services') for and on behalf of EC and which shall be defined in the 'Statement of Work' hereinafter known as 'Statements') issued to and accepted by ECPL. In performing its obligations under this Agreement. ECPL shall undertake the Development Services in India and on customer site on need basis.

1.2 Scope of Work : The scope of work shall be outlined in each Statement as may be agreed between the parties hereto from time to time. ECPL will provide adequate staff to complete the development services specified in the Agreement."

19. The supply made to the parent company represented the total turnover of the taxpayer. Shri Ostwal further submitted that for computation of ALP both the taxpayer and the TPO accept the applicability for Transactional Net Margin Method (TNMM) . With reference to balance sheet and profit and loss account of the taxpayer, he pointed out that accounts were prepared by taxpayer on the lines accounts were prepared in America by the parent company and accordingly much higher depreciation has been claimed in the accounts. He pointed out the difference in rates of depreciation as claimed in the account and as provided in Schedule XIV of the Indian Companies Act. The same is as under :—

20. However, in light of statutory requirement of the provisions of the Indian Companies Act, the accounts are to be prepared and depreciation claimed as per Schedule XIV of the Companies Act. After taking correct depreciation as above, the total operating profit works out to Rs. 82,46,869 and total operating cost at Rs. 94,378,716. The PLI i.e., operating profit with operating cost works out at 8.74 per cent. The adjusted figures are available at page 73 of the Paper book which are as under :—

Statement of computation of revised operating profit margins on operating cost of assessee : E-gain Communication Private Ltd.

21. Shri Ostwal did not refer to or draw our attention to the transfer pricing study furnished by the taxpayer but contended that even from the working of the TPO, it can be shown that the taxpayer had carried transaction with its associated concern at arm's length. Certain transactions on well-accepted principles are to be ignored. The principles applicable in this case, according to Shri Ostwal are as under :—

(1) That loss making companies were liable to be ignored for comparison as the taxpayer was a captive company. This is provided even in OECD guidelines.
(2) Companies having income from other sources like interest and dividend, which have nothing to do with business of software development, are also to be ignored. At any rate, even the Indian statutory regulation provided that while making caparison, adjustments are to be made for the differences in entities. According to Shri Ostwal, interest or divided or income from mutual fund was an income which has required to be excluded through suitable adjustments to make data used by the TPO as reliable and dependable. In this connection, Shri Ostwal drew our attention to the following specific entities taken by the TPO for comparison.

(i) Thirdware Solutions Ltd. which had shown PBIT of 67.65 per cent. Copy of profit and loss account of above company collected from the public domain with its annual report is available in the paper book. The profit and loss account is available at page 201 of the paper book. On examination of above accounts, it is seen on the receipt side, under the head 'Sales and other income' the taxpayer has shown 'other income' at Rs. 1,41,55,687. The detail given as per Schedule 13 is as under :—

"Schedule 13 : Other Income

22. Schedule XIV of the balance sheet further shows that above company was in the trading of software in the relevant period. It was purchasing licenses and clearing them. Purchase and sale of license is not a business which can at all be compared with software business. The balance sheet further makes it clear that the company has paid wealth tax advance and was not involved in development of technology. It did not have any income from development of software but had income from mutual funds.

23. The second company required to be excluded is WTI Advance Technologies Ltd. showing PBIT of 54.72 per cent. It had income from 'other sources' at Rs. 3,83,12,091. The detail of other income as per Schedule 10 of balance sheet is as under :—

Schedule 10 : Other Income

24. The above chart showed the gross income from interest, profit on investment, dividend and other miscellaneous sources of income. If profit from other sources is excluded, then profit would be less than Rs. 60 lakh. 25. The third company which required adjustment was Zenith Infotech Ltd. The margin profit for that company as per the correct calculation would work out to 2.98 per cent as against 5.65 per cent taken by the TPO. Effect on profit margin of companies after excluding non-business items (not relating to business of software) of above companies is as under :—

STATEMENT OF COMPUTATION OF REVISED OPERATING PROFIT MARGINS ON OPERATING COST (IN MILLIONS INR)

26. Shri Ostwal further submitted that if Thirdware Solution Ltd. were excluded from comparison as it was carrying on very different functions and had different sources of income, the adjusted operating profit margin of 19 companies taken into account by the CIT(A) would be 10.60 per cent (mean) as per working available at page 76 of the paper book which is as under :—

If range of ± 5 per cent permitted under section 92C(2) is taken into account, it will work out to Rs. 10,15,09,217 as against Rs. 10,25,68,917 shown by the assessee in the books of account. Thus profit on sales services to the associated enterprises were within ± 5 per cent range as per proviso to section 92C(2) of the Income-tax Act and therefore claim of arm's length transaction was fully established. Calculation of above is available at page 77 of the paper book and is as under :—

"Statement of Revised Arm's length price Range and ±5 per cent Adjustment

Assessee's sales to associated enterprise are within. ± 5 per cent range."

27. Shri Ostwal further submitted that if Thirdware Solution Ltd. is excluded, the margin of profit would work out to 8.47 per cent. It was further argued that Indian regulation on transfer pricing as contained in Rule 10B, in particular, 10B(1) (h) or OECD guidelines were not followed by the ld. TPO. The TPO failed to make adjustments for the differences in the comparable transactions. Even the decision of ITAT in the case of Mentor Graphics (Noida) (P.) Ltd. v. Dy. CIT [2007] 109 ITD 101 (Delhi) was not followed. In this connection, he read out paras 25, 26 and 27 of the above decision. He also referred to paras 1.2 and 1.4 of OECD guidelines. The TPO was also wrong in totally disregarding that the taxpayer was a captive company. Shri Ostwal also drew our attention to paras 1.47 and 1.48 of OECD guidelines which provide for taking a range. He also emphasized that the taxpayer has to show that the price charged by him was at arm's length, taking into account the lowest margin profit in the range. Shri Ostwal contended that there was total justification for exclusion of companies referred to above as these were not companies engaged in software development business. These were software trading companies and, therefore, not comparable. In the end, Shri Ostwal submitted that examined from any angle, there is hardly any justification for sustaining addition on account of adjustment made by the revenue authorities.

28. Ld. DR, on the other hand, submitted that profitability of the taxpayer was to be seen on a reality of business. In the assessment year 2004-05, the explanation of the taxpayer before the TPO was different from what was stated before the ld. CIT(A) . Now before the ITAT, a totally different explanation has been furnished. The parent company has suffered losses and, therefore, services by the taxpayer have been provided cost + 5 per cent was not a tenable argument. The agreement of the taxpayer with its parent company shows that it is a software development company. Page2 of the agreement under the title 'Services and scope of work', it is clearly provided that the taxpayer is dealing in software. He emphasized that profit shown by similar software development companies was more than 15 per cent. Ld. DR submitted that basic onus was on the taxpayer to show that transacts carried with associated enterprises (AE) were arm's length transactions. The ld. DR supported the arm's length price determined by the TPO who, according to the DR, had determined the ALP after discussion with the taxpayer and their representative. Objections on abnormalities or extraordinary circumstances of some comparable transactions were not put before the revenue authorities. After lot of screening of the relevant data of software companies, 20 comparables were finally selected for ultimate analysis by the TPO and by the CIT(A) . In making selection the TPO had taken into account element of risk, loss suffered by companies and gave opportunity to the assessee to show as to how profit margin of 3.86 per cent shown by the taxpayer was comparable. The assessee further could not point out any defect in the transfer pricing analysis carried out by the TPO. No reason has been furnished as to why entities having total range of Rs. 8 crore to Rs. 18 crore should be selected and taken as sacrosanct. The ld. TPO has determined ALP after taking into account reliable and cogent material collected from public domain. The argument advanced here and defects in comparable stated before the Tribunal were not stated before the Assessing Officer or ld. CIT(A) . The ld. DR accordingly justified the adjustment made by the Assessing Officer and upheld by the CIT(A) .

29. Shri Ostwal in rebuttal refuted the argument advanced by the ld. DR. It was submitted that the argument relating to defects in the comparable taken by TPO was specifically raised and noted by the ld. CIT(A) . He referred to page 3 para 2 and last para of impugned order of ld. CIT(A) . He, thus, contended that similar objections were raised before the ld. CIT(A) and is now being repeated here. The TPO did not give any opportunity to the taxpayer to raise these objections. Only nine companies were taken into consideration by the ld. CIT(A) to uphold the ALP determined by the TPO/Assessing Officer but now above two companies should be excluded or their margin of profit suitably adjusted and if adjustments are made, the average would work out to 10.95 per cent against 8.7 per cent shown by the taxpayer after adjustment of depreciation. The revenue authorities were also duly bound to carry functional and economic analysis for entities under comparison which they failed to do. The taxpayer had submitted such an analysis before the Assessing Officer,TPO. Copy of the same is available at page 239 of the paper book. There is no evidence to support the contention of the revenue that 15 per cent profit is being shown by similar software companies. At any rate, law of average cannot be applied to every case. Arm's Length Price has to be determined on the basis of facts and circumstances of the case in the light of the statutory provisions.

30. Shri Ostwal also relied upon para 3.5 of OECD guidelines to support his argument that adjustment for depreciation on account of excessive depreciation claimed is required to be made before taking marginal profit into consideration. Besides, he relied upon provisions of the Companies Act under which it is mandatory to provide for depreciation as per the relevant schedule. Ultimately, Shri Ostwal contended that no new argument was taken before the Tribunal and the case of the assessee was supported on the basis of material relied upon and used by the revenue authorities. He maintained that adjustment made was without any basis and was liable lo be deleted.

31. We have given careful thought to the rival submissions of the parties. The taxpayer is a captive company rendering services of software deve-lopment to its parent company. As per agreement between taxpayer and its parent company, it is to receive actual cost + 5 per cent mark up for the software developed and supplies to the parent company. Both the parties before us accept that Transactional Net Margin Method (TNMM) is the most appropriate method to determining Arm's Length Price in this case. The area of difference is limited to selection of comparables adopted by the TPO for working out average profit without making adjustment for the differences. The taxpayer has further contended that its profit be taken after adjustment of depreciation as per Chapter XIV of the Indian Companies Act. Out of the 20 entities, the dispute is restricted to mainly two entities namely. Thirdware Solutions Ltd. and WTI Advanced Technology Ltd. The reasons for exclusion of these two companies and for suitable adjustment while working, average profit margin have already been noted. Ld. DR is not correct in saying that the objections raised before us were not raised before the revenue authorities. The objection Ural the companies taken as comparable by the TPO are having income from 'other sources' than the business of software development was not raised but has been noted by ld. CIT(A) in para 2.1 of the impugned order. The name of WTI Advanced Technology is specifically mentioned. Again in para 2.2, the ld. CIT(A) has recorded taxpayer's objection that the companies taken by TPO for comparison have shown abnormal results by showing very high degree of profit. The companies specifically pointed out are at Sl. Nos. 7, 16, 17 and 19 of the list in TPO's order. Thirdware Solution Ltd. and WTI Advanced Technology Ltd. are at Sl. Nos. 16 and 19 respectively. However, the ld. CIT(A) did not consider above pertinent objection of the taxpayer nor referred to the calculations of average margin of profit filed before him. He look for comparison the companies showing turnover between Rs. 5 crore and Rs. 25 crore and worked out average PBIT/TE at 22.52 per cent and accordingly upheld the addition on account of adjustment. In the light of what is observed above, the objection of the revenue that new pleas are being advanced here has to be rejected. We proceed to consider the objection of the taxpayer on merit.

32. As already noted, both the parties agreed that Arm's Length Price in the present case is to be computed through TNMM. Rule 10B(1) (e) provides for determination of Arm's Length Price through TNMM after taking the following steps :—

"(e) transactional net margin method, by which—

(i) the net profit margin realized by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base;
(ii) the net profit margin realized by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base;
(iii) the net profit margin referred to in sub-clause ( ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market;
(iv) the net profit margin realized by the enterprise and referred to in sub-clause ( i) is established to be the same as the net profit margin referred to in sub-clause ( iii) ;
(v) the net profit margin thus established is then taken into account to arrive at an arm's length price in relation to the international transaction."

33. Sub-rule (3) of rule 10B requires that the difference between controlled and uncontrolled transactions is to be taken into account for dealing as under :—

"(3) An uncontrolled transaction shall be comparable to an international transaction if-

(i) none of the differences, if any, between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from, such transactions in the open market; or
(ii) reasonably accurate adjustments can be made to eliminate the material effects of such differences."

34. It is evident from above that while comparing transactions or enterprises (in case TNMM is applied) , the differences which are likely to materially affect the price, cost charged or paid in, or the profit in the open market are to be taken into consideration with the idea to make reasonable and accurate adjustment to eliminate the differences having material effect. If the differences are such that they cannot be subjected to evaluation, then transaction may have to be eliminated for the purposes of comparison. Even rule 10B(1) (c) (iii) requires the adjustment of differences between the international transaction and the comparable uncontrolled transactions. In the case of Mentor Graphics (P.) Ltd. v. Dy. CIT, this issue has been thoroughly discussed and it has been laid down that even while applying TNMM, suitable adjustment for difference on account of FAR and other relevant factor is to made. In that decision, the Bench also look into account OECD guidelines on application of TNMM method and observed as under :—

"36.2 In TPO's views, the Transaction Net Margin Method being more tolerant to minor functional differences, there was no need to carry functional and other analysis to find difference in transactions. For this purpose, he relied upon para 7.27 of OECD report of July 1995. In our opinion, para 3.27 has been taken by TPO out of context. In the Guidelines the strength and weaknesses of the Transaction Net Margin Method has been compared with other methods and one strong point stated has been overemphasized by the TPO. This is what has been stated in para 3.27 :—

3.27 One strength of the transactional net margin method is that net margins (e.g., return on assets, operating income to sales, and possibly other measures of net profit) are less affected by transactional differences than is the case with pride as used in the CUP Method. The net margins also may be more tolerant to some functional differences between the controlled and uncontrolled transactions than gross profit margins. Differences in the functions performed between enterprises are often reflected in variations in operating expenses Consequently, enterprises may have a wide range of gross profit margins but still earn broadly similar levels of net profits.

36.3 Extracts from other Paras 3.29, 3.34, 3.35, 3.37 and 3.39 of the same guidelines would clearly show that the inference drawn is one-sided. These paras are as under :—

3.29 There are also a number of weaknesses to the transactional net margin method. Perhaps the greatest weakness is that the net margin of a taxpayer can be influenced by some factors that either do not have an effect, or have a less substantial or direct effect, on price or gross margins. These aspects make accurate and reliable determinations of arm's length net margins difficult. Thus, it is important to provide some detailed guidance on establishing comparability for the transactional net margin method, us set forth in sub-section (c) (1) below.

3.34 Prices are likely to be affected by differences in products, and gross margins are likely to be affected by differences in functions, but operating profits are less adversely affected by such differences. As with the resale price and cost plus methods that the transactional net margin method resembles, this, however, does not mean that a mere similarity of functions between two enterprises will necessarily lead to reliable comparisons. Assuming similar functions can he isolated from among the wide range of functions that enterprises may exercise, in order to apply the method, the profit margins related to such functions may still not be automatically comparable where for instance, the enterprises concerned carry on those functions in different economic sectors or markets with different levels of profitability. When the comparable uncontrolled transactions being used are those of an independent enterprise, a high degree of similarity is required in a number of aspects of the associated enterprise and the independent enterprise involved in the transactions in order for the controlled transactions to be comparable; there are various factors other than products and functions that can significantly influence net margins.

3.35 The use of net margins can potentially introduce a greater element of volatility into the determination of transfer prices for two reasons. First, net margins can be influenced by some factors that do not have an effect (or have a less substantial or direct effect) on gross margins and prices because of the potential for variation of operating expenses across enterprises. Second, net margins can be influenced by some of the same factors, such as competitive position, that can influence price and gross margins, but the effect of these factors may not be as readily eliminated. In the traditional transaction methods, the effect of these factors may be eliminated as a natural consequence of insisting upon greater product and function similarity.

3.37 Assume, for example that a taxpayer sells top quality video cassette records to an associated enterprise, and the only profit information available on comparable business activities is on generic medium quality VCR sales. Assume that the top quality VCR market is growing in its sales, has a high entry barrier, has a small number of competitors, and is with wide possibilities for product differentiation. All of the differences are likely to have material effect on the profitability of the examined activities and compared activities, and in such a case would require adjustment. As with other methods, the reliability of the necessary adjustments will affect the reliability of the analysis. It should be noted that even if two enterprises are in exactly the same industry, the profitability may differ depending on their market shares, competitive positions, etc.

3.39 The transactional net margin method may afford a practical solution to otherwise insoluble transfer pricing problems if it is used sensibly and with appropriate adjustments to account for differences of the type referred to above. The transactional net margin method should not be used unless the net margins are determined from uncontrolled transactions of the same taxpayer in comparable circumstances or, where the comparable uncontrolled transactions are those of an independent enterprise, the differences between the associated enterprises and the independent enterprises that have a material effect on the net margin being used are adequately taken into account. Many countries are concerned that the safeguards established for the traditional transaction methods may be overlooked in applying the transactional net margin method. Thus where differences in the characteristics of the enterprises being compared have a material effect on the net margins being used, it would not be appropriate to apply the transactional net margin method without making adjustments for such differences. The extent and reliability of those adjustments will affect the relative reliability of the analysis under the transactional net margin method.

37. It is clear that even when TNMM method is applied to determine arm's length price as per OECD guidelines, functional profile, assets, assumed risks of controlled and uncontrolled transaction are to be seen while screening. Besides, it is not possible to ignore specific Indian regulations on the subject. We have already noted the relevant sub-rules (2) and (3) of rule 10B of Income-tax Rules, which specifically require to consider for comparison 'the functions performed assets employed ... and risks assumed by respective parties'. In Rule 10(B) (1) (c) of Income-tax Rules providing for determination through TNMM, it is clearly provided in clause (iii) 'the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the difference if any'. These regulations have force of law and notwithstanding OECD guidelines, the TPO cannot refuse to consider specific characteristics of transaction, functions performed and assets employed as has been done in this case. Total disregard of regulations non-application of filters as above has resulted in faulty selection of comparison. All sizes of companies have been selected, only commonality being their dealings in softwares. We are unable to hold and approve the approach of TPO as correct."

35. We further find that the provisions on transfer pricing in US also provide for "adjustment" for the differences while applying a method similar to TNMM. The method is described as 'comparable profit method'. Para 1.482-5 of Internal Revenue Service, Treasury is as under:—

"(2) Comparability - (i) In general. The degree of comparability between an uncontrolled taxpayer and the tested party is determined by applying the provisions of 1.482-1(d) (2) . The comparable profits method compares the profitability of the tested party, measured by a profit level indicator (generally based on operating profit) , to the profitability of uncontrolled taxpayers in similar circumstances. As with all methods that rely on external market benchmarks, the greater the degree of comparability between the tested party and the uncontrolled taxpayer, the more reliable will he the results derived from the application of this method. The determination of the decree of comparability between the tested party and the uncontrolled taxpayer depends upon all the relevant facts and circumstances, including the relevant lines of business, the product or service markets involved, the asset composition employed (including the nature and quantity of tangible assets, intangible assets and working capital) , the size and scope of operations, and, the stage in a business or product cycle.

(iii) Other comparability factors. Other factors listed in para 1.482-1(d) (3) also may be particularly relevant under the comparable profits method. Because operating profit usually is less sensitive than gross profit to product differences, reliability under the comparable profits method is not as dependent on product similarity as the resale price or cost plus method. However, the reliability of profitability measures based on operating profit may be adversely affected by factors that have less effect on results under 'the comparable uncontrolled price, resale price and cost plus methods. For example, operating profit may be affected by varying, cost structures (as reflected, for example, in the age of plant and equipment) , differences in business experience (such as whether the business is in a start-up phase or is mature) , or differences in management efficiency (as indicated, for example, by objective evidence such as expanding or contracting sales or executive compensation over time) . Accordingly, if material differences in these factors are identified based on objective evidence, the reliability of the analysis may be affect.

(iv) Adjustments for the differences between the tested party and the uncontrolled taxpayers. If there are differences between the tested party and an uncontrolled comparable that would materially affect the profits determined under the relevant profit level indicator, adjustments should be made according to the comparability provisions of 1.482-1(d) (2) . In some cases, the assets of an uncontrolled comparable may need to be adjusted to achieve greater comparability between the tested party and the uncontrolled comparable. In such cases, the uncontrolled comparable's operating income attributable to those assets must also be adjusted before computing a profit level indicator in order to reflect the income and expenses attributable to the income, and expense attributable to the adjusted assets. In certain cases, if may also be appropriate to adjust the operating profit of the tested party and comparable parties. For example. where there are material differences in accounts payable among the comparable parties and the tested party, it will generally be appropriate to adjust the operating profit of each party by increasing it to reflect an imputed interest charge on each party's accounts payable. As another example, it may be appropriate to adjust the operating profit of a party to account for material differences in the utilization of or accounting for stock-based compensation [as defined by 1.482-7(d) (2) (i) ] among the tested party and comparable parties."

36. It is thus evident from above that both OECD guidelines and US regulations insist on necessary adjustments for difference on issues affecting profitability. The transactional net margin method may afford a practical solution to otherwise insoluble transfer pricing problems if it is used sensibly and with appropriate adjustments to account for differences of the type referred to above. Similarities and dissimilarities of the transactions under comparison are to be scrutinized to see differences of situations, circumstances and environment. Any difference which materi- ally affects the market value is to be given a serious consideration. The degree of comparability between the tested party and the uncontrolled taxpayer with parameters like nature or line of business, product or service market, the assets composition employed, the size and scope of operation, the stage of business or product cycle are required to be seen. In case of uncontrolled entity, operative income attributable to assets other than assets under consideration is to be adjusted before taking transaction for working mean margin of profit. Income and expenses of the segment of total business may have to be considered. Depending on facts and circumstances of the case, 'It may also be appropriate to adjust the operative profit of tested party and comparable parties'. But when we examine the orders of the revenue authorities, we do not find that the comparable or the tested panics were scrutinized to find differences, which needed adjustments. We may not agree with the taxpayer that only entities having turnover between Rs. 8 to Rs. 18 crore were to be selected for comparison. But we see no justification for considering oversized companies as taken by the TPO. The ld. CIT(A) was justified in taking entities having turnover between Rs. 5 crore to Rs. 25 crore but he was in error in considering turnover as the only relevant factor needed to be considered for a proper analysis. What about a large number of other factors which materially affect the profit? The functions performed, assets employed, risk taken (FAR) analysis was also required to be undertaken as per the Transfer Pricing regulation and other guidelines. This was not done, which renders the comparison as unsound and unreliable. When taxpayer's ld. representative had specifically pointed out that companies at Sl. No. 16 to 19, namely, Thirdware Solution Ltd. and WTI Advanced Technology Ltd. were showing extraordinary results and had income from sources other than business of software development, the ld. CIT(A) did not care to examine the above contention or to verify the grievances raised by the taxpayer but confirmed the adjustments made. In these circumstances, we are inclined to hold that the approach and the order the ld. CIT(A) was legally incorrect and the order impugned before us cannot be upheld without material changes.

37. A cursory look at the chart in the assessment order of 20 compatibles would reveal that the margin of profit shown by Thirdware Solutions Ltd. and WTI Advanced Technology is extraordinary at 67.65 per cent and 54.72 per cent respectively. Therefore, it was necessary for the tax authorities to examine whether these entities have rightly been taken as comparables for application of Most Appropriate Method.

38. Para 1.47 of OECD guidelines is to the following effect :—

"1.47 Where the application of one or more methods produces a range of figures, a substantial deviation among points in that range may indicate that the data used in establishing some of the points may not be as reliable as the data used to establish the other points in the range or that the deviation may result from features of the comparable data that require adjustments. In such cases, further analysis of those points may be necessary to evaluate their suitability for inclusion in any 'arm's length range."

39. The aforesaid guidelines lay down the same principles as are reflected in the relevant Rule 10D quoted above. If there are material differences, then those differences are to be considered and suitable adjustment made. The revenue authorities were in error in not making those adjustments. Now, Mr. Otswal has placed before us clinching evidence to show that the above two companies had income from other sources like interest on deposit, dividend income and income from sale of licenses, which jacked up profit margin of these companies. By no stretch of imagination, the above type of income could be included for purposes of comparison whereas the tested party was carrying business of software development, if it was not possible to work out and exclude receipts and expenditure of above category of incomes, not relating to software development, then these companies could not be taken as comparable companies. The ld. CIT(A) did not offer any comment. We are not in a position to reject the contention of Mr. Ostwal that these companies were trading in software and were giving licenses for use of software. Thus, line of business of these companies was different from the business of the taxpayer involved exclusively in the development of software for its parent company. On facts and material on record, we are of the view that the above two companies were required to be excluded. The ld. counsel has filed results of the comparable companies after excluding above companies. The ld. DR during the course of hearing or ld. CIT(A) in the impugned order did not find any defect in the working furnished by the assessee. As per the working given, the profit margin of the taxpayer is quite comparable with average profit margin taken into account by the revenue other than two companies mentioned above. Therefore, in our opinion, there is no justification for making addition or adjustment for arm's length price shown by the taxpayer.

40. We further agree with the contention of the ld. counsel for the taxpayer that the benefit of adjustment was required to be given in working the margin of profit of the taxpayer for not undertaking any risk in the transactions involved with its parent company. However, evaluation of above risk in the present case is not necessary as even otherwise the margin of profit shown by the taxpayer has fully satisfied the arm's length price benchmark.

41. The learned DR had also raised some objection to the revised margin of profit shown by the taxpayer by taking lower rate of depreciation. This objection, in our opinion, is without any substance. The depreciation is required to be worked out under the Indian Companies Act and, as provided in the Schedule thereto. Depreciation cannot be computed as per American rules applicable to the parent company. Therefore, Mr. Ostwal was correct in adjusting margin of profit of the taxpayer.

42. In the light of above discussion, the addition on account of 'adjustment' in Arm's Length Price is deleted. No other point was argued before us during the hearing of the appeal.

43. In the result, the appeal of the assessee is allowed.