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Tribunal Order Summary — Four Soft (Assessee) v. Revenue — AY 2007-08

Factual and Procedural Background

This appeal by the assessee (a private limited company engaged in software services and enterprise solutions) challenges the assessment under section 143(3) read with section 144C for assessment year 2007-08. The assessee had several wholly owned overseas subsidiaries and other group entities and declared international transactions with associated enterprises (AEs), including provision of software services, receipt of services, interest on loans to subsidiaries and reimbursements. The assessee filed its return on 30-10-2007 declaring income after claiming deduction under section 10A.

During scrutiny, the Assessing Officer referred transfer pricing issues to the Transfer Pricing Officer (TPO). The TPO rejected the assessee's transfer pricing study (which had used CUP as most appropriate method and TNMM as supplementary) and applied TNMM with a set of comparables selected from databases, making substantial TP adjustments (including on software services, interest on loans, and corporate guarantee). The Assessing Officer incorporated the TPO's adjustments in the draft assessment, and the Dispute Resolution Panel (DRP) sustained most TPO adjustments but excluded one comparable, reducing the TP adjustment. The final assessment raised a demand. The assessee filed this appeal raising multiple grounds challenging the transfer pricing adjustments and other additions/disallowances.

Legal Issues Presented

  1. Whether the assessee's internal CUP/ external CUP analysis and the supplementary TNMM application establish arm's length price (ALP) for software development services with AEs, specifically addressing the correctness of the TPO's rejection of the assessee's TP study.
  2. Whether bad debts and reimbursements were correctly included in operating cost for determining operating margin under TNMM (i.e., should such items be excluded and segmental financials used).
  3. Whether certain companies selected by the TPO are comparable to the assessee for TNMM benchmarking (challenge to selection of specific comparables).
  4. Whether international loans in foreign currency should be benchmarked to LIBOR (plus a margin) rather than to domestic corporate bond rates (i.e., appropriate benchmark for interest on loans to AEs).
  5. Whether a loan subsequently converted into equity should be recharacterised by the TPO as a loan for TP purposes (re-characterisation of equity into loan).
  6. Whether the corporate guarantee provided by the assessee to its AE constitutes an 'international transaction' and, if so, what is the appropriate fee/ALP for that corporate guarantee.
  7. Whether disallowance under section 14A (and Rule 8D) for exempt income (dividends) was correctly computed for the year in question.
  8. Whether expenditure of Rs.43,92,874 towards purchase of software for third parties is capital or revenue in nature (admissibility / depreciation if capital).
  9. How exemption under section 10A should be computed with respect to allocation of certain expenditures between export turnover and total turnover.
  10. Levy of interest under sections 234B and 234C (not adjudicated independently as it is consequential).

Arguments of the Parties

Assessee's (Appellant's) Arguments — as advanced by the learned AR

  • On TP method: The TP provisions require comparing controlled transactions with uncontrolled transactions under comparable circumstances; Rule 10B lists comparability criteria. The assessee's internal CUP and TNMM analyses (with operating profit to operating cost as PLI) show the transactions are within ALP.
  • On operating cost composition: Bad debts, R&D and reimbursements (payments made on behalf of AEs and recovered at cost) are not related to AE transactions and thus should be excluded from operating cost for AE segment margin computation; the assessee submitted segmental financials showing differing margins for AE and non-AE transactions and maintained separate books/segmental data.
  • On selection of comparables: Several companies selected by the TPO are not functionally comparable (e.g., companies with product revenue, very large scale players with intangibles and brand value like Infosys and Wipro, or entities not meeting employee cost or segment filters). The assessee relied on coordinate bench precedents (including its own earlier order) to exclude or limit comparables.
  • On interest benchmarking: Interest on foreign-currency loans should be benchmarked to internationally accepted rates (LIBOR) plus an appropriate margin (assessee offered LIBOR + 2%), not to domestic corporate bond rates; international loan comparables are LIBOR-based.
  • On conversion of loan to equity: The conversion was done in compliance with FEMA/RBI regulations; conversion involved share premium in existing shares (no change in shareholding percentage) and thus was in substance equity; activity may be a shareholder activity and not a chargeable transaction.
  • On corporate guarantee: A corporate guarantee provided by parent is not equivalent to a bank guarantee and does not necessarily involve the same cost; by prior Tribunal order the issue was treated differently and the retrospective amendment to section 92B must be considered; corporate guarantee fee should not be mechanically equated to bank guarantee commission.
  • On section 14A disallowance: Rule 8D is not retrospective and for years prior to AY 2008-09 disallowance must be computed on a reasonable basis; assessee relied on tribunal/High Court precedent to contest Rule 8D's retrospective application.
  • On purchase of software for third parties: The purchases were acquired for resale/for supplying to customers (revenue in nature) and so should not be treated as capital; relied on Amway/IBM and other precedents and asked for application of functional tests laid down by Special Bench.
  • On section 10A computations: Certain expenses must be reduced from both export turnover and total turnover when computing section 10A exemption.

Revenue / Respondent's Arguments — as advanced by the learned DR

  • The TPO has examined and rejected the assessee's TP documentation with detailed reasons and has correctly applied TNMM and selected comparables; the DRP has endorsed the TPO's approach in most respects.
  • Interest on loans and other TP adjustments were appropriately determined by the TPO/DRP (including use of domestic corporate bond rates for interest benchmarking and treating certain transactions as within ALP adjustments).
  • Corporate guarantee falls within the scope of international transaction and, post amendment to section 92B (Explanation (i)(c)), the TPO was justified in determining ALP for the corporate guarantee.
  • Disallowances and characterization of expenditures were addressed by the DRP and should be upheld in the absence of compelling reasons to disturb the findings.

Table of Precedents Cited

Precedent Rule or Principle Cited For Application by the Court
ITA No.1495/Hyd/2010 (Four Soft — assessee's own case, dated 09-09-2011) Use of segmental financials and exclusion of bad debts/reimbursements when computing net margin for AE transactions; adoption of segmental profitability for ALP determination. The Bench followed this coordinate-bench decision and remitted the ALP determination to AO/TPO directing them to consider AE segmental financials and exclude bad debts/reimbursements while computing margins.
Virtusa (India) (P.) Ltd. v. Dy. CIT [2013] 38 taxmann.com 165 (Hyd.-Trib) Companies that have mixed product and service revenues and lack segmental data should be excluded as comparables for pure software service providers. The Court followed this coordinate-bench view in excluding certain comparables (e.g., Avani Cimcon, Lucid Software) where segmental data was unavailable or product revenue was significant.
World (Subcontinent) (P.) Ltd. v. Asstt. CIT [2011] 47 SOT 1/12 taxmann.com 310 (Delhi) Cited by the assessee in support of TP comparability/contentions (as part of authorities relied upon). Listed among decisions relied upon by the assessee; the Tribunal notes reliance but primarily follows coordinate-bench authorities when directing exclusion/adjustment of comparables.
Birlasoft (India) Ltd. v. Dy. CIT (IT Appeal No.3830 (Delhi) of 2010) Decision relied upon by assessee on TP comparability/filters. Included among authorities relied on by the assessee; Tribunal's directions on comparables reflect consideration of such precedents alongside other coordinate-bench decisions.
Technimount ICB (P.) Ltd. v. Addl. CIT (IT Appeal No.7099 (Mum.) of 2010) Decision cited by the assessee in support of comparability/contentions. Considered among the supporting authorities relied upon by the assessee; Tribunal's findings on comparables align with coordinate-bench reasoning cited.
Dy. CIT v. Quark Systems [2010] 38 SOT 307 (Chd) (Special Bench) Principle that a party is not estopped from objecting to a comparable previously selected if valid reasons are shown. The Court accepted that prior selection of a comparable by the assessee does not estop it from challenging that comparable before a higher forum; relied on this to permit the assessee to challenge Infosys/Wipro inclusion.
Siva Industries & Holdings Ltd. v. Asstt. CIT [2011] 46 SOT 112 / 11 taxmann.com 404 (Chennai) Supports the proposition that foreign currency loan ALP should be LIBOR-based (international benchmark). The Tribunal cited this and other authorities in directing AO/TPO to adopt LIBOR plus an appropriate margin for benchmarking interest on foreign-currency loans and remitted the matter for verification of actual LIBOR.
Cotton Naturals India (P.) Ltd. v. Dy. CIT [2014] 146 ITD 662 / 32 taxmann.com 219 (Delhi) Supports LIBOR-based benchmarking for international loan transactions. Referenced by the assessee and considered by the Tribunal in directing LIBOR+ approach for interest ALP; matter remitted to AO/TPO to verify applicable LIBOR and margin.
Perot Systems TSI (India) Ltd. v. Dy. CIT [2010] 37 SOT 358 Authority relied upon by TPO to support recharacterisation of a transaction where a loan was later converted to equity. The Tribunal noted that Perot Systems was relied upon by the TPO but found factual differences (RBI/FEMA approvals, nature of conversion) and remitted the issue to AO/TPO for fresh examination rather than applying Perot Systems automatically.
Besix Kier Dabhol, SA v. Dy. CIT [2011] 131 ITD 299 / 8 taxmann.com 37 (Mumbai) Authority cited by the assessee to argue that TPO cannot re-characterise transactions. Mentioned by the assessee; Tribunal remitted the loan-to-equity recharacterisation issue for fresh consideration rather than adopting a single precedent conclusively.
Micro Inks Limited v. Income Tax [2013] 144 ITD 610 / 36 taxmann.com 50 (Ahd.-Trib) Authority relied upon by the assessee on characterization/re-characterisation questions. Placed before the Tribunal by the assessee; Tribunal directed AO/TPO to re-examine loan-to-equity conversion facts and agreements and provide opportunity to be heard.
Mahindra & Mahindra Ltd. v. Dy. CIT [2012] 54 SOT 146 / 24 taxmann.com 267 (Mumbai) Discussed interaction between earlier tribunal decisions and retrospective amendment to section 92B (treatment of guarantees as international transactions). The Tribunal relied on the logic in this decision when holding that after retrospective amendment, corporate guarantees fall within 'international transaction' but that the rate applied must be appropriate (not mechanically bank guarantee rate).
Glenmark Pharmaceuticals v. Addl. CIT [2014] 43 taxmann.com 191 (Mum.-Trib) Applied a method to determine an appropriate corporate guarantee fee (in that case 0.53%). The Tribunal directed the TPO to determine corporate guarantee fee by applying the approach in Glenmark (and as applied by Infotech Enterprises) and remitted the issue to TPO to determine appropriate rate, allowing the assessee to produce comparables if any.
Infotech Enterprises Ltd. v. Addl. CIT [2014] 41 taxmann.com 364 (Hyd.-Trib) Followed Glenmark approach for corporate guarantee ALP and remitted the issue to TPO. The Tribunal followed the Hyderabad Bench decision and remitted the corporate guarantee rate determination to the TPO to follow that methodology.
Godrej & Boyce vs. DCIT (328 ITR 81) Principle that Rule 8D is not retrospective; for years prior to AY 2008-09 disallowance under section 14A must be computed on "reasonable basis". The Tribunal directed AO to rework disallowance under section 14A on a reasonable basis in line with this precedent and previous coordinate-bench directions (assessee's own case for AY 2006-07).
Amway India Enterprises v. Dy. CIT [2008] 111 ITD 112 (Delhi) (Special Bench) Set out factors/tests to determine whether acquisition of computer software is capital or revenue (nature of business, centrality, longevity, associated capital expenditure, degree of organizational change, etc.). The Tribunal directed AO to apply these criteria to decide whether the software purchase is capital or revenue in nature and to allow depreciation if held capital, remitting for fresh examination.
IBM India v. CIT [2007] 290 ITR 183 (Madras) Authority cited by the assessee relevant to treatment of software-related expenditures. Referenced by the assessee in support of the claim that software purchases can be revenue in nature; Tribunal ordered AO to apply Special Bench criteria (Amway) and decide afresh.
Cit v. Agnity India Technologies Pvt. Ltd. [2013] 219 Taxman 26 / 36 taxmann.com 289 (Delhi HC) Authority referenced in relation to comparability and treatment of very large companies as non-comparable due to size and other factors. The Tribunal cited the High Court decision in support of excluding very large companies (Infosys, Wipro) as comparables due to size, intangibles and scale differences.

Court's Reasoning and Analysis

The Tribunal examined the record (assessee's TP documentation, TPO order, DRP directions and earlier coordinate-bench decisions) and proceeded issue-by-issue. The core analytical steps taken by the Tribunal were:

  1. On the TP study for software development services the Tribunal observed that the assessee had furnished segmental financials showing separate margins for AE and non-AE transactions (39.26% for AEs v. 6.30% for non-AEs in the segmental data reproduced in the TP order). The Tribunal found that the TPO rejected segmental data with broad allegations and appears to have misallocated segmental expenditures (including bad debts and reimbursements) into operating cost for AE transactions. The Tribunal held that costs not related to AE transactions (bad debts, reimbursements at cost) cannot be included in operating cost for AE margin computation.
  2. The Tribunal followed a prior coordinate-bench decision in the assessee's own case (ITA No.1495/Hyd/2010) which directed that segmental financials be considered and bad debts/reimbursements excluded when computing net margin for AE transactions. Respectfully following that authority, the Tribunal remitted the ALP determination back to the Assessing Officer/TPO with explicit directions: to verify segmental financials and determine ALP considering only operating costs allocable to the AE segment and to consider receivables/payables only in respect of AE transactions (i.e., restrict working capital adjustment to AE transactions).
  3. On selection of comparables, the Tribunal heard detailed submissions and dealt with several specific companies:
    • Avani Cimcon: Following Virtusa, excluded as comparable due to mixed product/service revenue and lack of segmental data.
    • Infosys & Wipro: Excluded as comparables because of disproportionate size, turnover, brand/intangible advantages and diversified activities; Tribunal noted the assessee may challenge a comparable it earlier selected if valid reasons exist (citing Quark Systems).
    • Ishir Infotech: Excluded because it failed the employee cost filter as per coordinate-bench precedent (Virtusa).
    • Lucid Software: Excluded for mixed product/service revenue and lack of segmental data (following Virtusa).
    • Megasoft: The Tribunal directed that only segmental margin for software development services be considered (following Virtusa precedent guidance).
    • Tata Elxsi: Remitted to AO/TPO to consider assessee's functional differences and decide comparability afresh.
    The Tribunal therefore directed exclusion or limited use of various comparables and remitted ALP computation to AO/TPO in light of these findings.
  4. On interest benchmarking for foreign-currency loans, the Tribunal recalled its coordinate-bench decision in the assessee's own case for AY 2006-07 and other authorities holding that ALP for international foreign-currency loans should be LIBOR-based. The Tribunal directed AO/TPO to determine ALP using LIBOR plus an appropriate mark-up (the AO/TPO may consider assessee's offer of LIBOR + 2%), and remitted the matter for verification of actual LIBOR prevailing in the relevant year.
  5. On recharacterisation of a loan converted into equity, the Tribunal noted that TPO relied on Perot Systems but found factual distinctions: in the present case conversion was undertaken with RBI approval under FEMA and involved conversion into share premium of existing shares. The Tribunal concluded that the Perot Systems ratio could not be mechanically applied without a deeper factual examination. The Tribunal remitted the issue to AO/TPO to analyze the loan agreement and surrounding facts afresh and to give the assessee an opportunity of being heard.
  6. On corporate guarantee, the Tribunal observed that after the retrospective amendment to section 92B (Explanation (i)(c)) corporate guarantees fall within the scope of 'international transaction'. However, the Tribunal found that the TPO had applied a bank guarantee commission rate (3.75%) mechanically, which is inappropriate for corporate guarantees. Citing Glenmark and Infotech Enterprises decisions, the Tribunal remitted the matter to the TPO to determine an appropriate corporate guarantee fee using the method applied in Glenmark/Infotech and permitted the assessee to produce comparables if available.
  7. On section 14A disallowance, the Tribunal relied on the coordinate-bench precedent and Godrej & Boyce holding that Rule 8D is not retrospective; accordingly, for pre-AY 2008-09 the AO must compute disallowance on a reasonable basis. The Tribunal remitted the matter to AO for reworking the disallowance in accordance with that ratio.
  8. On purchase of computer software: The Tribunal referred to the Amway Special Bench test (set out in detail in the Amway decision) for deciding whether software acquisition is capital or revenue in nature. The Tribunal directed AO to apply those criteria to the specific software items in question, allow depreciation if held capital, and to decide afresh after giving the assessee an opportunity.
  9. On computation of exemption under section 10A: The Tribunal held (following consistent bench decisions) that certain expenses should be reduced from both export turnover and total turnover while computing 10A exemption and directed AO accordingly.
  10. Procedural and consequential issues such as levy of interest under sections 234B and 234C were left undecided as they are consequential.

Holding and Implications

Final Disposition: The Tribunal partly allowed the appeal for statistical purposes and remitted multiple issues to the Assessing Officer/Transfer Pricing Officer for fresh consideration in accordance with the directions recorded in the order.

Direct effects and directions: The Tribunal's core rulings and practical consequences for the parties are:

  • The ALP determination for software development services is remitted to AO/TPO with directions to use segmental financials, exclude bad debts/reimbursements not related to AE transactions, restrict working-capital adjustments to AE receivables/payables, and reconsider comparables (excluding or limiting certain companies as directed).
  • Comparables specifically excluded or limited: Avani Cimcon, Infosys Technologies Ltd., Wipro Ltd., Ishir Infotech Ltd., Lucid Software Ltd.; Megasoft to be used only on segmental margin basis; Tata Elxsi to be reconsidered by AO/TPO for functional differences.
  • Interest on foreign-currency loans to be benchmarked using LIBOR + appropriate margin (AO/TPO to verify actual LIBOR and consider assessee's LIBOR + 2% offer).
  • The loan-to-equity conversion issue is remitted for factual examination of the agreement and RBI/FEMA approvals; AO/TPO to decide after providing opportunity to assessee.
  • Corporate guarantee ALP is to be re-determined by AO/TPO using the methodology in Glenmark/Infotech (and AO/TPO to consider assessee's comparables if produced).
  • Section 14A disallowance to be reworked on a reasonable basis in line with Godrej & Boyce and coordinate-bench directions.
  • Expenditure on purchase of software to be examined under the Amway Special Bench criteria; if held capital, depreciation must be allowed in accordance with that decision.
  • Section 10A computation: AO to reduce specified expenses from both export turnover and total turnover as directed.
  • Levy of interest under sections 234B/234C is left to be addressed consequentially.

Precedential effect: The Tribunal primarily followed existing coordinate-bench and other Tribunal/High Court authorities. It did not purport to lay down a novel principle: rather, it applied and followed prior decisions (including the assessee's own earlier Tribunal order and other coordinate-bench rulings) and remitted factual and valuation issues for re-administration consistent with those precedents. No new broad legal principle was created; the decision directs AO/TPO to apply established legal tests and benchmarks and to permit factual verification and opportunities to be heard.

Result: Appeal partly allowed for statistical purposes; multiple issues remitted to AO/TPO for fresh consideration in accordance with the Tribunal's directions.

Source: Extracted and summarized from the Tribunal order text provided (Order of Judicial Member Saktijit Dey).

    Four Soft Pvt. Limited, Hyderabad v. Dcit, Cir-1(3) Hyderabad .

    ORDER

    Saktijit Dey, Judicial Member - This appeal by the assessee is directed against the assessment order passed u/s 143(3) read with sec. 144C of the Act pertaining to the assessment year 2007-08.

    2. Briefly stated, assessee is a private limited company. The assessee has following wholly owned subsidiaries overseas which are its Associated Enterprises(AE):—

  • 1. Four soft Denmark A/s
  • 2. Four soft Singapore Pte Ltd
  • 3. Four soft BV Netherland
  • 4. Four Soft Malaysia Sdn Bhd
  • 3. Besides, the assessee company also exercises control over four subsidiaries in USA, Netherland, Germany and U.K. through its wholly owned subsidiary in Netherlands. The assessee company basically is engaged in providing services in enterprise solutions by operating software products and services in ITES sector for the logistics and supply chain management market place. As stated by the assessee, as a result of global acquisitions and expansions the assessee and its route companies have established in more than 10 countries with 379 customer installations. The assessee, for the impugned assessment year filed its return of income on 30-10-2007 declaring total income of Rs.93,22,780/- after claiming deduction u/s 10A of the Act. During the financial year 2006-07 relevant to the assessment year under dispute, the assessee declared international transactions with its AE as under:—

  • 1. Provision of software services to AEs Rs.18,75,30,850
  • 2. Receipt of services from AEs Rs.5,65,77,968
  • 3. Interest received on loans to subsidiary Rs.25,80,423
  • 4. Reimbursement to AEs Rs.4,91,57,236/-
  • 5. Reimbursements by AEs Rs.3,07,21,617
  • 4. That apart, assessee has entered into international transaction with non AEs also. The total revenue earned towards provision of software services both to AEs and non AEs is to the tune of Rs.36,49,46,821/-. After deducting operating cost of Rs.31,79,98,626/-, the margin shown by the assessee is Rs.4,69,48,195/- which worked out to 14.76% of the revenue earned. For the purpose of establishing arms length price (ALP) of international transactions with AEs, assessee undertook a transfer pricing study carried out by an independent external consultant. As per the functional analysis, assessee having been categorised as a risk mitigated contract service provider was selected as tested party in respect of the provision of software services to AEs. Comparable Uncontrolled Price (CUP) method was selected as most appropriate method to determine the ALP. As the derived hourly rate received from the AEs was higher than the hourly rate received from Non AEs, the transaction was concluded to be at arm's length. The assessee also undertook supplementary analysis under Transaction Net Margin Method (TNMM) with operating profit to operating cost as the profit level indicator (PLI) to determine the ALP. On considering the nature of international transaction, economic conditions, differences in business or product life cycles and other similar factors and also the fact that the audited financial data for the financial year 2006-07 was not available in all cases, financial data of financial year 2004-05 and financial year 2005-06 was also considered along with financial data for the financial year 2006-07. On the aforesaid basis, a search was carried out in the public data bases which yielded 27 comparable companies with weighted average arithmetic mean of 14.2%. Since assessee's operating margin is shown at 14.76% as against 14.2% of the comparable companies, the price charged for the international transactions with AEs was considered to be within arm's length range.

    5. During the scrutiny assessment proceedings, the Assessing Officer noticing that the assessee had entered into international transactions, made a reference to the transfer pricing Officer (TPO) for determining the arm's length price. In course of the TP proceedings, the TPO called for various information from the assessee as well as from outside sources u/s 133(6) of the Act and on considering the material available on record rejected the TP study done by the assessee by observing that the same is not reliable due to various defects and deficiencies as noted by the TPO in his order. The TPO rejecting the CUP method adopted by the assessee selected TNMM as the most appropriate method for determining ALP. The primary reason for rejecting the TP study is, use of multiple year data and not confining to the financial data of the current financial year. The TPO further observed that the assessee while selecting/rejecting comparables has not considered the verticals/horizontals of software industry and companies engaged in software development were treated as comparables on a broad spectrum. The Assessing Officer did not accept the CUP method followed by the assessee because of the fact the assessee has arrived at the average rates charged to AEs for comparison under internal CUP. The TPO alleged that the assessee has not furnished any evidences as to how the average rates were arrived at even though a show cause notice was issued to the assessee. It is further mentioned in the TP order that since the assessee did not furnish any evidence like the cost audit etc., and only furnished a letter wherein it was stated that an independent CA was appointed for verifying the hourly rate for the software services provided to the AEs and non AEs. Since no other evidence was submitted by the assessee like cost audit etc., the TPO issued summons to the CA who has worked out the hourly rate and recorded a statement from him. As noted by the TPO, the concerned CA Sri Venkatraman stated that the average rate was arrived at by him on the basis of information submitted by the assessee and not on the basis of books of accounts. When a specific query was made with regard to the basis of pricing done by the assessee in charging their services to AEs, the concerned CA stated that he is not aware of the same. The Assessing Officer noted that the statement recorded from the CA clearly revealed the fact that the assessee has not maintained any separate books of accounts for the transactions entered into with its AEs and non AEs. He therefore was of the view that the average billing rates worked out by the assessee cannot be relied upon for applying the arm's length margin for the international transactions entered with its AEs. The TPO further noted that under the segmental margin worked out in respect of the international transactions pertaining to the AEs and non AEs, the assessee has allocated different expenses under AEs and non AEs which shows the services provided to the AEs and non AEs cannot be compared. The TPO was of the view that in case of CUP the functional similarity between the services rendered by tested party and the uncontrolled transaction is more stringent. It is very difficult to get the data regarding the man hour charge for various levels of employees in the case of independent enterprises. The TPO therefore felt that CUP method cannot be considered to be most appropriate method due to non availability of reliable data in the public domain. Having rejected the TP study submitted by the assessee and selected TNMM as the most appropriate method, the TPO by applying certain filters proceeded to search data bases for selecting comparables. In this regard, the TPO also exercised his powers under section 133(6) of the Act for obtaining information from certain companies. In the process the TPO selected 26 companies as comparables with an average margin of 26.36%. While doing so the TPO included reimbursement transactions also in operating cost and arrived at the arm's length price of international transactions with its AE from software services at Rs.27,44,96,144/- which resulted in a transfer pricing adjustment of Rs.3,78,08,058/-. Apart from the aforesaid TP adjustment on account of provision for software development services to AEs, the TPO also made TP adjustment of Rs.17,72,097/- with regard to interest on loans provided to AEs. While arriving at aforesaid TP adjustment, the TPO considered 'BBB' rated bonds in India as comparable transactions and determined the bench mark rate of 14%. The TPO further noted that during the year under consideration the loan provided by the assessee to its subsidiary 4S Netherlands of Rs.18,89,30,971/- was converted into share premium on existing equity. The TPO concluded that the equity is nothing but loan and accordingly made TP adjustment by charging interest at the rate of 14% which amounted to Rs.2,57,50,336/-. The TPO also noted that during the year the assessee has provided corporate guarantee for the loan taken by 4S BV for acquisition of DCS group. The TPO proceeded to determine the ALP on the corporate guarantee at the rate of 3.75% and made an adjustment of Rs.2,61,79,350/-. Thus, the total TP adjustment recommended by the TPO was to the tune of Rs.9,15,09,841/-.

    6. In consequence of the order passed by the TPO, the Assessing Officer passed a draft assessment order incorporating the adjustments suggested by the TPO. That apart, the Assessing Officer made further additions by re-working the deduction u/s 10A of the Act and making disallowance u/s14A. As a result, the total income was determined at Rs.11,59,47,911/- in the draft assessment order. The assessee challenged the additions proposed in the draft assessment order by filing objections with the Dispute Resolution Panel (DRP). The DRP rejected almost all the contentions of the assessee with regard to the transfer pricing issues except in respect one of the comparables selected by the TPO viz., M/s Celestial Labs, which the DRP excluded from the list of comparables. As a result of which the arms length margin was reduced to 25.1% consequently resulting in reduction of TP adjustment to Rs.3,34,44,867/-. That apart, the DRP also directed the Assessing Officer to allow deduction/s 10A on the amount disallowed towards software expenses. In pursuance to the directions of the DRP , the Assessing Officer passed the impugned assessment order raising a demand of Rs.5,25,41,563/- including interest charged u/s 234B and 234C of the Act.

    7. Being aggrieved of the assessment order so passed the assessee has preferred the present appeal raising a number of grounds.

    8. Ground Nos. 1 to 15 relate to TP adjustment on provision of software development services. Since the issues raised in the aforesaid grounds are overlapping, we will deal with the issues specifically argued by the learned AR before us at the time of hearing. The learned AR confined his submissions to the following issues with regard to the transfer pricing adjustment in respect of software development services.

  • (i) Non application of CUP/TNMM to internal uncontrolled transactions of the assessee for determining ALP.
  • (ii) Bad debts, reimbursements should not be included in the operating cost.
  • (iii) Selection of incomparable as comparables by TPO
  • So far as the first and second issues are concerned, the learned AR submitted that the TP provisions require testing the arms length nature of a transaction with AE by comparing the price/margins of the controlled transactions with price/margin of comparable transactions under comparable circumstances engaged by uncontrolled enterprises, in other words, uncontrolled transactions. It was submitted that comparability exists if the uncontrolled transactions and circumstances sufficiently resembles the assessee's transaction to provide a reliable measure of an arm's length price/margin. He further submitted that Rule 10B provides the comparability criteria for an international transaction with an uncontrolled transaction. In terms with the aforesaid Rules the assessee has furnished enough evidence and data to show that price charged for internal comparable transactions are at par with external comparable transactions. The learned AR submitted that the TPO has erred in computing the operating margin for the transactions with AEs and non AEs and also erred in allocating the bad debts such as R & D to the AE segment which apparently are in respect of third party transactions only. It was submitted that even as per the computation of TPO the margin with the AEs and non AEs is the same. Hence, the transaction has to be held to be within arm's length. The Ld. AR submitted that process adopted by the TPO for determining ALP is erroneous as he has included in the operating cost net payable to AE's which includes expenses already debited in the P&L A/c in the operating cost for determining ALP of the intra group software services transactions. Further, the TPO included reimbursements by AEs for payments made on their behalf, in operating cost for determining ALP of the transactions relating to provision of software services. He submitted, the amounts paid on behalf of the AEs were recovered from the AE's at cost. Similarly, AE's also on certain instances made payments on behalf of the assessee which were reimbursed to the AE. It was submitted that these receipts/payments were made at cost without mark up because the AEs for administrative convenience paid the amounts on behalf of the clients. No significant additional functions performed or risks assumed by the assessee/AEs and payments are not related to the operations of the assessee but the AE. In support of such contention, the learned AR relied upon a decision of the co-ordinate bench in assessee's own case in ITA No.1495/Hyd/2010 dated 9-9-2011 relating to assessment year 2006-07. He also relied upon the following other decisions:—

  • 1. Destination of the World (Subcontinent) (P.) Ltd. v. Asstt. CIT [2011] 47 SOT 1/12 taxmann.com 310 (Delhi)
  • 2. Birlasoft (India) Ltd. v. Dy. CIT [IT Appeal No. 3830 (Delhi) of 2010] and
  • 3. Technimount ICB (P.) Ltd. v. Addl. CIT [IT Appeal No. 7099 (Mum.) of 2010, dated 25-2-2011]
  • 9. The learned DR, on the other hand, submitted that the TPO has exhaustively dealt with this aspect while rejecting the TP documentation by giving detailed reasons. Therefore, the assessee's contention cannot be accepted.

    10. We have heard the parties and perused the material on record. On perusal of the TP order it is to be seen that in para 2.4.1 the TPO has admitted that the assessee has submitted segmental financials separately in respect of AE and non-AE transactions. As per the aforesaid segmental financials (reproduced at page 4 of TP order), the margin in respect of transactions with AEs is 39.26% as against margin of 6.30% in respect of non AE transactions. Therefore, when segmental details have been furnished by the assessee the TPO should have considered them properly instead of rejecting them with broad and sweeping allegations. It seems, the TPO has not properly allocated the segmental expenditures. If the bad debts etc. are not related to AE transactions they cannot be considered as part of operating cost for determining ALP of the transactions with AE. Similarly, reimbursement on cost to cost basis also cannot be included in the operating cost. Unfortunately, the DRP without dealing with this issue at depth has finished its job by simply commenting that TPO has dealt with the issue appropriately. In this context, it is to be noted that when identical issue was agitated by the assessee before the Tribunal for the assessment year 2006-07, a coordinate bench of this Tribunal in ITA No. 1495/Hyd/10 dt. 09/09/2011 held as under:

    "15. We have considered the rival submissions and perused the material on record. First, we will take up the issue relating to the adjustments made by the assessing officer in respect of the international transactions with Four Soft Limited, Hyderabad vs Assessee on 9 September, 2011its associated enterprises in the software development services. It is the contention of the assessee that bad debts incurred by the assessee company are in respect of transactions, which are not related to associated enterprises. This contention of the assessee has not been controverted by the Revenue by bringing any material on record before us. It is the contention of the learned counsel for the assessee that such bad debts cannot be taken into account for computing the margin of the assessee from the transactions with the associated enterprises in respect of software development services. The learned counsel for the assessee has also filed before us a comparative chart explaining the computation of Net Margin, excluding the bad debts and clearly demonstrated before us that if the bad debts/reimbursements are excluded for the purpose of computing the margins on the transactions relating to the associated enterprises, the net margin comes to 19.07%, which is well comparable with the Arms Length Margin of 19% determined by the Transfer Pricing Officer. In our considered view, for computing the net margin of the assessee for the purposes of transfer pricing, only the cost related to the transaction with the Associated Enterprises has to be considered and accordingly, we approve that segmental financials is to be considered for the purpose of arriving at the net margin on the international transaction with the assessee's enterprise in respect of software development services. In that process, bad debts/reimbursements has to be excluded and segmental profitability has to be adopted. We find support in this behalf from various decisions of the Tribunal relied upon by the learned counsel for the assessee duly filing copies thereof in the paper-book, which have been noted hereinabove. That being so, the TPO should have determined the Arms Length Price for the international transactions with associated enterprises considering only the operating cost allocable to the Associated Enterprises segment. Since the assessing officer had no occasion to verify the veracity of the segmental financials prepared by the assessee company, for limited purpose, we direct the assessing officer to verify the segmental financials prepared by the assessee company and adopt the same for arriving at the net margin on the international transaction with AEs in respect of software development services. We direct accordingly."

    Respectfully following the aforesaid observation of the coordinate bench in assessee's own case, we remit this issue back to the file of the Assessing Officer/TPO to determine the ALP in terms with the direction of the coordinate bench extracted hereinabove. Another contention of the ld. AR is while making TP adjustment and computing working capital adjustment under TNMM, the TPO has considered margins at the entity level. It was therefore contended that the TP adjustment has to be restricted only to transactions with AE. We find force in the contentions of the ld. AR. The Assessing Officer/TPO is directed to determine the ALP only considering the receivables and payables in respect of transactions with AEs only.

    11. The next issue is with regard to selection of certain companies as comparables. Though, in view of our direction in para 10 above the other issues relating to determination of ALP of software development services may have become redundant, but considering the fact that parties were heard at length on the issue of selection of certain comparables by the TPO, We prefer to record our finding in respect of each of them as under:—

    Avani Cimcon Technologies Limited:—

    11.1 The learned AR submitted that the aforesaid company cannot be treated as comparable to the assessee as it is not a purely software service provider and has revenue from products also. The segmental details of the said company are also not available in the public domain. It was further contended by the learned AR that the ex-ordinarily high margin of profit at 52.59% shown by the company also makes it incomparable to the assessee. In support of such contention, the learned AR relied on a number of decisions of different benches of the Tribunal including Hyderabad Benches, copies of which are placed in paper book.

    11.2 The learned DR, on the other hand, submitted that the TPO has selected the comparables after considering all aspects and affording due opportunity to the assessee. Therefore, there being functional similarity between the assessee and the comparable company it cannot be treated as incomparable.

    11.3 We have heard the submissions of the parties and perused the orders of the revenue authorities as well as other material on record. The assessee has basically sought exclusion of aforesaid company on two grounds, firstly, this company has revenue from both product and software services and segment-wise data is not available and secondly, it is contended that the company has shown super normal profit of 52.59% against average margin of other comparables. It is very much evident from the TP order that the assessee has been categorised as a software development service provider. Coordinate bench of this Tribunal in the case of Virtusa (India) (P.) Ltd. v. Dy. CIT [2013] 38 taxmann.com 165 (Hyd.-Trib) after following some other decisions of the Tribunal has held this company not to be treated as comparable as this company is also into product development. As segmental details of operating income of software development services and sale of software products are not available, it could not be ascertained whether the profit ratio of this company can be taken into consideration for comparing with the assessee. As the aforesaid decision of the coordinate bench pertained to the same assessment year i.e. AY 2007-08, following the same we hold that this company cannot be treated as comparable to the assessee.

    Infosys Technologies Ltd. & Wipro Limited

    11.4 Objecting to the aforesaid companies being treated as comparables, the learned AR submitted that these two companies cannot be considered to be comparable to a captive service provider like the assessee , not only because of the quantum of revenue earned by them but also on account of various other factors. It was submitted that these companies command a premium in the pricing of their products and services due to the goodwill, reputation and brand value. It was submitted that due to scale of operation they not only enjoy economies of scale in the lower cost of infrastructure facilities and employees but also earning profit. It was submitted that both the companies have diversified activities including products, consultancy and solutions. Both these companies own intangibles and assume considerable risk which results in earning higher profits. In support of such contention the ld. AR relied upon a number of decisions, copies of which are placed in the paper book.

    11.5 The learned DR strongly contesting the contentions of the assessee submitted that so far as Infosys Technologies is concerned, the assessee itself has selected the said company in the TP documentation. Therefore, the assessee cannot again object to the TPO selecting the said company as comparable. He further submitted that only because both these companies have brand value and are big in size they cannot be treated as incomparable to the assessee.

    11.6 In rejoinder, the ld. AR submitted that the assessee selected Infosys on the basis of three years data whereas TPO has considered only current year data. The learned AR further submitted that if the assessee has mistakenly selected a comparable, it cannot be estopped from objecting to the selection of that comparable in proceedings before higher forum. In this context, the learned AR relied upon the Income-tax Appellate Tribunal Special Bench decision in case of Dy. CIT v. Quark Systems [2010] 38 SOT 307 (Chd) (SB)

    11.7 We have considered the submissions of the parties and perused the materials on record. On considering the same, we are of the view that both these companies cannot be considered as comparable to the assessee due to various factors such as their size, turnover, brand value, scale of operation, diversified activities and owning of intangibles. That besides as can be seen from para 10.1 of TPO's order he has applied the turnover filter by excluding companies having turnover of less than Rs.1 crore from software development services. Applying the same logic, he should also have fixed an upper limit and excluded companies with extra-ordinarily high turnover. As can be seen from the TP order, the turnovers of Infosys Technologies Limited and Wipro Limited during the year under consideration are Rs.13,149 crores and 9616.09 crores respectively as against Rs. 36 crores of the assessee. Though it is a fact that the assessee in the TP documentation, has selected Infosys Technologies Ltd. as comparable but that cannot prevent the assessee from objecting to the aforesaid company being selected as comparable, if there are valid reasons for doing so. In this context, the contention of the learned AR that the assessee has selected Infosys Limited on the basis of three years financial data, whereas the TPO considered only the current year data also needs to be appreciated. Therefore, considering the enormity of turnover of these two companies as well as other relevant factors, the aforesaid companies cannot be treated as comparable to the assessee in any manner. This view of ours is also in tune with the view expressed by different Benches of this Tribunal as well as that of the Hon'ble Delhi High Court in the case of Cit v. Agnity India Technologies Pvt. Ltd…. [2013] 219 Taxman 26/36 taxmann.com 289 . We therefore direct the Assessing Officer /TPO to exclude them while computing ALP.

    ISHIR INFOTECH LTD

    11.8 Objecting to this company being treated as comparable, the learned AR submitted that this company cannot be a comparable to the assessee as the said company does not satisfy the employee cost filter threshold limit of 25% applied by TPO. It was submitted that as per the information available from the Annual Report of the said company employee cost as a percentage of operating revenue is only 3.96%. In support of such contention, the learned AR relied upon the decision of co-ordinate bench of this Tribunal in case of Virtusa (India) (P.) Ltd. (supra) and various other decisions.

    11.9 The learned DR, on the other hand, relied on the reasoning of the TPO.

    11.10 We have heard the parties and perused the materials on record. So far as this company is concerned, the assessee has sought exclusion of the aforesaid company on the ground that this company fails employee cost filter. In this context, the learned AR has relied upon the decision of co-ordinate Bench of this Tribunal in case of Virtusa (India) (P.) Ltd. (supra). On a perusal of the order passed in case of Virtusa (India) (P.) Ltd.(supra), we find that the co- ordinate bench has held that Ishir Infotech Limited cannot be treated as comparable as it does not qualify the employee cost filter as well as RPT filter . Respectfully following the aforesaid decision of the co-ordinate bench, we also direct the Assessing Officer/TPO to exclude this company from the list of comparables.

    Lucid Software Limited:—

    11.11 We have heard the parties and perused the materials on record. The main objection of the assessee with regard to the aforesaid company is that it earns revenue both from product development as well as software services for which segmental data is not available. In support of such contention, the learned AR has relied upon the decision of co-ordinate bench in the case Virtusa (India) (P.) Ltd. (supra). On perusal of the order passed in case of Virtusa (India) (P.) Ltd. (supra), it is to be seen that the co-ordinate bench has excluded the aforesaid company accepting assessee's contention that segmental data in respect of sale of products and software services are not available. Following the aforesaid decision of the coordinate bench we direct exclusion of the aforesaid company from list of comparables.

    Megasoft Limited

    11.12 We have heard the parties and perused the materials on record. The main objection of the assessee with regard to the aforesaid company is that this is predominantly a product development company and margin from software development services is 23.11%. As can be seen, in case of Virtusa (India) (P.) Ltd. (supra), the co-ordinate bench of the Tribunal while considering the assessee's objection with regard to the aforesaid company had directed the Assessing Officer/TPO to take only segmental margin of this company for computing ALP. Respectfully following the aforesaid order of co-ordinate bench, we also direct the Assessing Officer /TPO to consider only the segmental margin of this company for the relevant assessment year for computing ALP.

    Tata Elxsi Limited

    11.13 We have heard the parties and perused the materials on record. The assessee has sought exclusion of the aforesaid company by placing reliance upon the information furnished by said company u/s 133(6) wherein the said company has admitted that it cannot be treated as comparable with any other software service provider due to complex nature of its business. Considering the submissions of the parties we remit the issue of comparability of this company back to the file of Assessing Officer/TPO for considering afresh. The Assessing Officer/TPO shall duly consider assessee's objection with regard to functional differences between assessee and Tata Elixi Ltd. before deciding the issue of comparability. Accordingly, we direct the Assessing Officer/TPO to determine the ALP of the price charged by the assessee to its AE towards provision of software development services in terms with our direction in the preceding paragraphs. If on such determination of ALP the price charged by the assessee for the international transactions with its AE is found to be within arm's length, the same is to be accepted.

    11.14 We make it clear that we have refrained from dealing with the other grounds relating to transfer pricing adjustment of software development services segment as they were specifically not argued by the learned AR.

    12. Ground No.16 relates to determination of arm's length interest rate at 14% for loans provided to Foursoft BV, Netherlands.

    13. During the Transfer Pricing proceedings, the TPO noticed that the assessee has advanced loan of 10,90,000 Singapore Dollars to its AE. The assessee has charged interest at 8.30% as was the case in the preceding assessment year. In the TP documentation the assessee had justified the interest charged by stating that as per the prime lending rates issued by Monetary Authority of Singapore during the year 2007, the average lending rates adopted by Singapore banks while granting loans to domestic Singapore borrowers is 5.3%. Hence, interest charged by the assessee at 8.3% is within arm's length.

    14. The TPO however, refused to accept the contention of the assessee and determined the arms length price of interest at 14% by applying the rate of domestic corporate bonds. The DRP also confirmed the view of TPO.

    15. The Ld. A.R. submitted that interest on international loans given in foreign currency has to be benchmarked in terms with internationally accepted LIBOR rate and arms length price of interest cannot be determined by applying the interest rates of domestic corporate bonds. The Ld. A.R. submitted that interest rate may be determined at LIBOR + 2%. In support of such contention the Ld. A.R. relied upon the decision of the ITAT, in assessee's own case for A.Y. 2006-07 (ITA.No.1495/Hyd/2010) as well as in case of Siva Industries and Holdings Ltd. v. Asstt. CIT [2011] 46 SOT 112 (URO)/11 taxmann.com 404 (Chennai) and Cotton Naturals India (P.) Ltd. v. Dy. CIT [2014] 146 ITD 662/32 taxmann.com 219 (Delhi) .

    16. The Ld. D.R. on the other hand, relied upon the orders of DRP and TPO.

    17. We have heard the parties. This issue was considered by this Tribunal in assessee's own case for the A.Y. 2006-07 (supra). The Coordinate Bench while deciding the issue held as under :

    "19. We have considered the rival submissions and perused the materials available on record. We do not find any merit in the arguments of the learned departmental representative as we find that the ALP is to be determined for the international transaction, that is, on international loan and not for the domestic loan. Hence, the comparable, in respect of foreign currency loan in the international market, is to be LIBOR based which is internationally recognised and adopted. In our considered view, the DRP rightly directed the assessing officer to adopt the LIBOR plus for the purpose of TP adjustment. Our view is fortified by the decision of the Madras Bench in the case of Siva Industries (supra). We do not find any merit in the arguments of the learned counsel for the assessee that the DRP should have adopted the EURIBOR for the purpose of the TP adjustments, as we find that the mostly used and recognised benchmark rate for international loan is LIBOR based. Hence, the DRP rightly directed the assessing officer to adopt the LIBOR rates. We confirm the directions of the DRP. However, by considering the contentions of the learned counsel for the assessee that the actual LIBOR was 4.42% as against the 5.78% approved by the DRP, we find it proper to restore this issue to the file of the assessing officer, to verify the correctness of the claim made by the assessee company. In view of this matter, we remit this matter to the file of the assessing officer to verify the actual average LIBOR prevailed in the financial year relevant to the assessment year under consideration and adopt the interest rate 4.42% if the claim of the assessee is found correct. The ground raised by the assessee on this issue is partly allowed for statistical purpose".

    18. The other decisions relied upon by the Ld. A.R. also express the view that arms length price of loan transaction with AE should be on the basis of LIBOR + percentage point. Respectfully following the view expressed by the Coordinate Benches as aforesaid, we direct the A.O./TPO to determine the arms length interest on loan advanced by assessee to its AE by applying LIBOR + percentage points. In this context, A.O./TPO may consider assessee's offer of LIBOR + 2% to find out whether the interest charged by the assessee to its AE is within arm's length. With the aforesaid direction, we remit the issue to the file of the A.O./TPO for deciding afresh, after extending opportunity of being heard to the assessee.

    19. Ground No. 17 relates to re-characterisation of equity into loan.

    20. The TPO noticed that the assessee during the F.Y. 2005-06 has advanced loan of Rs.18,89,30,971/- to its AE, Foursoft BV, Netherlands and received interest @ 6.23%. However, during the F.Y. 2006-07 the outstanding loan as on 31.03.2006 was converted to equity. The TPO noticed that, in TP documentation the assessee has not analysed the said transaction stating that the transaction has no bearing on the profits of assessee. The TPO however, was not convinced with the explanation of the assessee. The TPO relying upon a decision of ITAT, Delhi Bench in case of Perot Systems TSI (India) Ltd. v. Dy. CIT [2010] 37 SOT 358 held that subsequent conversion of loan to equity will not change the character of the transaction, because when the parties entered into the transaction it was only a loan. Accordingly, the TPO computed interest @ 14% on the amount of Rs.18,89,30,971/-and treated it as adjustment under section 92CA. the DRP also upheld the view of the TPO that subsequent conversion of loan into equity will not change its character.

    21. The Ld. A.R. submitted before us that assessee has provided loan to its 100% subsidiary in Netherlands, which was later converted into equity as per FEMA regulations. He submitted that in relation to conversion of loans into equity, no new shares were issued and the amount of loan was converted into share premium in relation to the existing shares, 100% of which is held by Foursoft India. It was submitted, though fresh shares could have been issued but as assessee is holding 100% of equity, it does not have any impact on the shareholding interest of assessee in its subsidiary in Netherlands. Since 100% of the equity is held by assessee, the entire dividends declared by the subsidiary in Netherlands would be received by assessee. The Ld. A.R. referring to Chapter VII of OECD guidelines submitted that an activity performed by a group member solely because of its ownership interest in the capacity of a shareholder is a 'shareholder activity' and would not justify a charge to the recipient company. The Ld. A.R. submitted that the decision in Perot Systems TSI (India) Ltd. (supra) will not be applicable to the assessee firstly because it is not a case of interest free loan but equity capital contribution and secondly, unlike in assessee's case the loan was not converted into equity. The Ld. A.R. relied upon a decision of ITAT, Mumbai Bench in case of Besix Kier Dabhol, SA v. Dy. CIT [2011] 131 ITD 299/[2010] 8 taxmann.com 37 wherein it is held that TPO cannot re characterise the transaction. He also relied upon the following two decisions.

  • 1. Micro Inks Limited v. Income Tax [2013] 144 ITD 610/36 taxmann.com 50 (Ahd.-Trib)
  • 2. Cotton Naturals India (P.) Ltd. ( supra)
  • 22. We have heard the parties and perused the materials on record. It is clear from the TP Order that the TPO has arrived at his conclusion primarily relying upon the decision of the Tribunal in case of Perot Systems TSI (India) Ltd. (supra). However, on going through the decision of Perot Systems TSI India Ltd. (supra) it is to be seen that the Bench after examining the agreement between the parties did not find anything to suggest that loan was to be treated as a quasi capital. Further, the Bench observed that nothing was brought to its notice to show that there was any technical problem for which loan could not have been contributed as capital originally, if it was actually meant to be capital contribution. However, in the case before us, it is specifically contended by the assessee that loan was extended in view of FEMA regulations. It is also a fact acknowledged by the TPO that the assessee has obtained approval of the RBI for converting the loan into equity. Therefore, without properly analyzing the terms of the loan agreement in case of assessee and in case of Perot Systems as well as other relevant factual aspects one cannot apply the ratio of Perot Systems to assessee's case. As it appears, neither the TPO nor DRP have considered the issue at depth. We, therefore, remit this issue back to the A.O./TPO for considering afresh after properly examining the agreement as a whole and other relevant factual aspects. The assessee should be given a reasonable opportunity of being heard in the matter.

    23. Ground No.18 relates to determination of ALP at 3.75% on the corporate guarantee provided by the assessee to its AE.

    24. It is noted by the TPO, during the F.Y. 2005-06 the assessee has provided bank guarantees on behalf of its Overseas subsidiary, Foursoft BV, Netherlands for an amount of Rs.69,81,16,000/- which is continuing for the year under consideration also. The TPO following the order passed for A.Y. 2006-07 treated the commission changed by ICICI Bank at 3.75% arms length price for the corporate guarantee provided by the assessee to its AE worked out the TP adjustment of Rs.2,61,79,350/-. The DRP also rejected assessee's objection on the issue.

    25. We have heard the parties and perused the material on record. The sum and substance of the submissions made by the learned AR is, the corporate guarantee provided by the assessee cannot be equated to bank guarantee and resultantly the commission rate for bank guarantee cannot be applied to the corporate guarantee. It was submitted that the corporate guarantee is nothing but an additional guarantee provided by the parent company and it does not involve any cost or risk to the shareholders. It was submitted that since the corporate guarantee was given keeping in view paramount business interest of the parent company it has to be allowed as business expenditure. It is the further submissions of the learned AR that the retrospective amendment effected to section 92B of the Act, by Finance Act, 2012 by insertion of Explanation (i)(c) to section 92B also has not enlarged the scope of the 'international transaction' to include the corporate guarantee in the nature provided by the assessee. The learned AR further contended that the issue is covered in favour of the assessee by virtue of the order passed by the Tribunal in assessee's own case for AY 2006-07 (supra).

    25.1 The learned DR, on the other hand, submitted that by virtue of the amendment made to section 92B of the Act with retrospective effect from 01/04/2002, the corporate guarantee provided by the assessee is to be considered as an international transaction, and, therefore, the Assessing Officer was justified in determining arm's length price of such transaction.

    25.2 Having considered the submissions of the parties, we are unable to accept the contention of the learned AR that corporate guarantee of the nature provided by the assessee will not come within the meaning of international transaction in terms with section 92B of the Act. It is not disputed that section 92B of the Act has been amended by the Finance Act, 2012 with the insertion of Explanation I (c) with retrospective effect from 01/04/2002. Explanation (i)(c) to section 92B, reads as under:

    "capital financing, including any type of long-term or short-term borrowing, lending or guarantee, purchase or sale of marketable securities or any type of advance, payments or deferred payment or receivable or any other debt arising during the course of business."

    25.3 A reading of the aforesaid clause from the Explanation would make it clear that the corporate guarantee provided by the assessee comes within the scope and ambit of 'international transaction' as per the aforesaid clause. Therefore, the contention of the learned AR that the issue is covered in favour of the assessee by virtue of the order passed in assessee's own case for AY 2006-07 no longer holds good since the order passed by the coordinate bench is prior to the amendment made to provision of section 92B of the Act. It will be pertinent to mention here that this issue was also considered by the ITAT Mumbai Bench in case of Mahindra & Mahindra Ltd. v. Dy. CIT [2012] 54 SOT 146/24 taxmann.com 267 . The coordinate bench of this Tribunal while considering similar argument advanced on behalf of the assessee by placing reliance on the decision of the Four Soft Ltd.(supra), held as under:

    "15.2 After hearing the rival submissions we feel that Assessing Officer will have to follow the decision of the ITAT Hyderabad or the amended provision of the Act in this regard. If the Finance Bill of 2012 is passed by the Parliament amending the provisions of section 92B, with effect from 1st April, 2002, he will have to ignore the decision of the ITAT Hyderabad. In case section 92B is not amended with retrospective effect, he should grant relief to the appellant."

    25.4 In the aforesaid view of the matter, we agree with the TPO that ALP of the corporate guarantee has to be determined as it falls within the scope and ambit of an international transaction after the retrospective amendment to section 92B. However, it appears that the TPO has applied the rate of 3.75%, which is applicable to bank guarantee issued by the bank. As the corporate guarantee is not in the nature of bank guarantee, the rate applicable to bank guarantee provided by the bank cannot be applied to corporate guarantee which is provided by a group company. In case of Glenmark Pharmaceuticals v. Addl. CIT [2014] 43 taxmann.com 191 (Mum.-Trib) , the Mumbai Bench of the Tribunal after analysing the facts in that case had held that 0.53% corporate guarantee rate in that case was appropriate. The ITAT Hyderabad Bench in case of Infotech Enterprises Ltd. v. Addl. CIT [2014] 41 taxmann.com 364 (Hyd.-Trib) while considering identical issue of determining ALP of corporate guarantee provided by the assessee to its AE followed the ratio laid down in case of Glenmark Pharmaceuticals (supra) and remitted the issue back to the TPO to decide the quantum of corporate guarantee rate by following the method adopted in case of Glenmark Pharmaceuticals (supra).

    26. Since the issue in the present case is identical to the issue decided by the ITAT, Hyderabad Bench in case of Infotech Enterprises Ltd. (supra), following the same, we also remit this issue to the file of the TPO to decide the quantum of corporate guarantee rates accordingly. If the assessee is able to bring on record any comparables with regard to corporate guarantee, the TPO may also consider the same while determining ALP of corporate guarantee. The TPO must provide a reasonable opportunity of being heard to the assessee before deciding the issue. This ground is allowed for statistical purposes.

    27. Ground No.19 relates to disallowance of Rs.14,49,523/- under section 14A of the Act.

    28. Facts in brief are, during the assessment proceedings the A.O. noticed that assessee has received exempt income in favour of dividend amounting to Rs.28,36,993/-. The A.O. applying Rule 8D disallowed under section 14A an amount of Rs.14,49,523/-. The assessee objected to the disallowance before DRP. However, the DRP sustained the disallowance made by the A.O.

    29. We have heard by the parties and perused the materials on record. This issue is squarely covered by the decision of the Tribunal in assessee's own case for the A.Y. 2006-07 in ITA.No.1495/Hyd/2010. The Tribunal has held as under :

    '23. The Ground No.19 relates to disallowance of expenditure under section 14A of the Act. This issue is covered by the judgment of the Bombay High Court in the case of Godrej & Boyce vs. DCIT reported in 328 ITR 81 wherein it was held that Rule 8D read with section 14A[2] of the Act is not arbitrary or unreasonable but can be applied only if assessee's method is not satisfactory. Rule 8D is not retrospective in nature and the same has to be applied from the assessment year 2008-09. For the earlier assessment years, disallowance has to be worked out on "reasonable basis" under section 14A [2] of the Act. Accordingly, we restore this issue to the file of the assessing officer to rework the disallowance on reasonable basis in accordance with the ratio laid down by the aforesaid judgment. The ground raised by the assessee is allowed for statistical purpose'.

    30. Respectfully following the aforesaid order of the Coordinate Bench, we remit the matter back to the file of the A.O. for deciding afresh in terms with the direction of the Tribunal extracted hereinabove. This ground is allowed for statistical purposes.

    31. Ground No.20 relates to disallowance of expenditure incurred of Rs.43,92,874/- towards purchase of software for third parties.

    32. During the assessment proceedings the A.O. noticing that the assessee has claimed expenditure of Rs.43,92,874/- towards purchase of software for third parties, disallowed the same by treating it as capital expenditure. The DRP though endorsed the view of the A.O. with regard to the nature of expenditure, but nevertheless directed the A.O. to examine admissibility of depreciation on such capital expenditure.

    33. The Ld. A.R. submitted before us that the assessee has purchased software such as Oracle, progress etc., from third parties sold to its customers. Accordingly, cost of purchase and sales are routed through profit and loss account. It was therefore submitted that the expenditure is allowable. In support of such contention, he relied upon the following decisions :

  • 1. Amway India Enterprises v. Dy. CIT [2008] 111 ITD 112 (Delhi) (SB)
  • 2. IBM India v. CIT [2007] 290 ITR 183 (Mad.).
  • 34. The Ld. D.R. supported the order of DRP and A.O.

    35. We have heard the parties and perused materials on record. As can be seen from the contention of the learned AR, the expenditure on purchase of computer software is claimed as revenue expenditure mainly relying upon the decision of Income-tax Appellate Tribunal, Delhi Special Bench in the case of Amway India Enterprises Vs. DCIT ((supra)). On a careful reading of the aforesaid decision, we find that the Special Bench has laid down certain parameters for determining the nature of expenditure incurred in acquiring software. The relevant portion from the decision is extracted hereunder for sake of convenience:

    "58. The following factors would be relevant to determine whether the advantage operates in the capital field or revenue field.

  • (i) Nature of business of the assessee : It is necessary to obtain an understanding of the business function or effect of a concern's software. Software normally functions as a tool enabling business to be carried on more efficiently. The scope, power, longevity of such a tool and its centrality to the functions of the business will all bear on its treatment.
  • In the case of M/s SQL Star international Ltd. one of the assessees in the cases referred to the Special Bench, the assessee company is engaged in the business of software development as well as running a training center to impart specialized training to the students in software technology. If the software were used in such business to impart training to the students, then the same would be part of the profit making apparatus of the assessee and consequently expenditure on software, capital.
  • Similarly, example of a travel agent can be cited here as an illustration wherein the expenditure incurred on acquisition of a software for the purpose of enabling the assessee to make booking of air tickets would be a capital expenditure because such a software certainly forms part of the profit making apparatus of the travel agency business inasmuch as the business of air ticket booking is done with the help of that software.
  • Another example which can be considered here is that of acquisition of Turbo Gold software for Rs. 17.61 lakhs by one of the assessees in the present case i.e. M/s Amway India Enterprises. As submitted before us, the said software helps in compression of size of e-mails sent through the Lotus Notes Mailing System and it includes licenses for 150 users who are using Lotus Notes Mailing System and software license for running on its server. If use of this software in the business of the assessee is limited to facilitate merely an effective and fast communication in order to increase its organizational efficiency, the same cannot be treated as forming part of the profit making apparatus of the assessee. On the other hand, if such software is being used by an assessee engaged in the business of placement agency where the applications from persons seeking jobs are invited through e-mail and are also forwarded to the concerned clients through e-mail, the same may form part of profit making apparatus of the assessee's business of placement agency and can be treated as a capital asset.
  • (ii) As a general rule it may be stated that the more expensive the computer software the more it is likely to be a central tool of the business and the more enduring is likely to be its effect adding to the profit earning apparatus. If there are associated capital expenditure like purchase of new computer equipment for running the software developed under a project, then it can be considered as capital expenditure. This is especially the case where the new hardware is not merely desirable but necessary for this purpose.
  • (iii) Degree of associated organisational change : Similarly the degree of change intended in the way operations are carried out as a result of the computer software, for example, savings in the number, and changes in the location, of staff used to provide services to customers will have a bearing. The more radical the changes, the more likely the expenditure will be capital. These changes are likely to be most radical when operations previously carried on manually are computerised.
  • (iv) It has to be borne in mind that computer software industry is of a fast changing nature. Therefore whatever software purchased by an assessee would become outdated much earlier than expected. The assessee has therefore to upgrade his software. An element of upgrading does not automatically make the expenditure capital. The presence of an element of upgrading, therefore, will not necessarily cause the expenditure in question to be capital.
  • 59. Our conclusions on the issue under consideration thus can be summarized, as under :

  • (i) When the assessee acquires a computer software or for that matter the license to use such software, he acquires a tangible asset and becomes owner thereof as held above relying on the decision of Hon'ble Supreme Court in the case of TCS ( supra).
  • (ii) Having regard to the fact that software becomes obsolete with technological innovation and advancement within a short span of time. It can be said that where the life of the computer software is shorter (say less than 2 years), it may be treated as revenue expenditure. Any software having its utility to the assessee for a period beyond two years can be considered as accrual of benefit of enduring nature. However, that by itself will not make the expenditure incurred on software as capital in nature and the functional test as discussed above also needs to be satisfied.
  • (iii) Once the tests of ownership and enduring benefit are satisfied, the question whether expenditure incurred on computer software is capital or revenue has to be seen from the point of view of its utility to a businessman and how important an economic or functional role it plays in his business. In other words, the functional test becomes more important and relevant because of the peculiar nature of the computer software and its possible use in different areas of business touching either capital, or revenue field or its utility to a businessman which may touch either capital or revenue field.
  • 60. Having laid down the criteria for determining the nature of expenditure incurred on acquisition of software, whether capital or revenue, we are of the view that these criteria need to be applied to determine the exact nature of expenditure incurred by the assessees in the present cases for acquiring different softwares. Since this exercise is required to be done in respect of each and every software independently having regard to the criteria laid down above, we are of the view that the matter needs to be restored back to the file of the AO for doing such exercise. The AO shall examine the question whether expenditure on computer software is capital or revenue in the light of the criteria laid down above after giving an opportunity of being heard to the assessees. If on such examination, the AO comes to the conclusion that the expenditure is capital expenditure, then the question regarding allowing depreciation will be decided in accordance with the principles laid down in the subsequent paras."

    36. In light of observation of the Income-tax Appellate Tribunal special Bench ((supra)), we direct the Assessing Officer to consider the claim of the assessee by applying the criteria laid down therein and decide the issue accordingly. Further, we make it clear that if at all the Assessing Officer concludes that the expenditure is capital in nature, then, he must allow depreciation keeping in view the ratio laid down by the Hon'ble Speical Bench ((supra)). This ground is considered to be allowed for statistical purposes.

    37. In ground No.21 the assessee has raised the issue of computation of exemption under section 10A by reducing certain expenditures only from the export turnover.

    38. The A.O. while computing exemption under section 10A of the Act reduced certain expenses from the export turnover on the ground that such expenditures are attributable to delivery of computer software outside India. The DRP also endorsed the view of A.O.

    39. We have heard the parties and perused the materials on record. This issue is no more Res Integra in view of a number of decisions of not only different High Courts but also different Benches of the Tribunal including Special Bench. Keeping in tune with such consistent view, we direct the A.O. to reduce such expenses both from export turnover and total turnover while computing exemption under section 10A of the Act.

    40. Ground No.22 relates to levy of interest under section 234B and 234C of the Act. Levy of interest being consequential is not required to be adjudicated upon at this stage.

    41. In the result, assessee's appeal is partly allowed for statistical purposes.

    SUNIL

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