The Karnataka High Court has dismissed the Revenue’s appeal concerning transfer pricing adjustments made in the case of a captive software development company, holding that the issues raised regarding the turnover filter, selection of comparables and working capital adjustment did not give rise to any substantial question of law.
The Bench of Chief Justice Vibhu Bakhru and Justice K.S. Hemalekha has observed that there was no prescribed turnover filter. However, it held that fixing a turnover limit of ₹200 crore could not be considered arbitrary in the circumstances. The purpose of selecting comparables is to identify entities that are as similar as possible to the assessee in terms of functional profile, assets and risks.
The appeal was filed by the Commissioner of Income Tax-III and the Deputy Commissioner of Income Tax, Bangalore, under Section 260A of the Income Tax Act, 1961, challenging the Income Tax Appellate Tribunal (ITAT), Bangalore Bench ‘C’ order dated November 21, 2014, relating to Assessment Year 2009-10. The dispute arose from transfer pricing adjustments made in respect of international transactions undertaken by the assessee with its Associated Enterprise (AE).
The assessee was engaged in developing computer software for its Associated Enterprise. For AY 2009-10, it filed its return of income on September 30, 2009, declaring total income of ₹30,97,850 after claiming an exemption of ₹17,54,94,079 under Section 10A of the Income Tax Act.
Since the return involved international transactions, the Assessing Officer made a reference under Section 92CA to the Transfer Pricing Officer (TPO). The assessee had prepared a transfer pricing study and adopted the Transactional Net Margin Method (TNMM) as the most appropriate method for determining the Arm’s Length Price (ALP).
The assessee had initially selected nine comparable companies, whose average profit margin on sales was 10.5%. Against this, the assessee had disclosed a margin of 13.08%, contending that its international transactions were at arm’s length.
The TPO accepted TNMM as the most appropriate method but disagreed with certain filters applied by the assessee and with some of the comparables selected by it.
After examining the assessee’s objections and considering additional comparables, the TPO selected 11 companies for the comparability analysis. These included Kals Information Systems Ltd., Akshay Software Technologies Ltd., Bodhtree Consulting Ltd., R S Software (India) Ltd., Tata Elxsi Ltd., Sasken Communication Technologies Ltd., Persistent Systems Ltd., Zylog Systems Ltd., Mindtree Ltd., Larsen and Toubro Infotech and Infosys Ltd.
The average mean margin of the selected comparables was 18.07%. After making working capital and risk adjustments, the TPO computed an excess of ₹20,50,06,773 over the amount disclosed by the assessee and directed a transfer pricing adjustment of that amount.
Based on the TPO’s directions, the Assessing Officer passed a draft assessment order proposing total income of ₹31,39,57,352 against the returned income of ₹30,97,850. The proposed assessment included the transfer pricing adjustment of ₹20.50 crore.
The assessee challenged the adjustment before the Dispute Resolution Panel (DRP). After the DRP issued its directions on December 12, 2013, the Assessing Officer passed the final assessment order on January 31, 2014.
The transfer pricing issues eventually reached the Karnataka High Court. In an earlier order dated July 2, 2018, the High Court had dismissed the Revenue’s appeal, holding that no substantial question of law arose for consideration.
At that stage, the High Court had relied upon its earlier decision in Prl. Commissioner of Income Tax v. Softbrands India Private Limited, under which disputes concerning selection of comparables or application of filters generally were not considered to raise substantial questions of law.
However, the Revenue challenged the Softbrands decision before the Supreme Court. The Revenue also challenged the July 2, 2018 order in the present matter, and the appeals were heard along with the Softbrands litigation.
The Supreme Court subsequently took a different view in SAP Labs India Private Limited v. Income Tax Officer and connected matters. It held that transfer pricing adjustment issues can give rise to questions of law because the Court may have to examine whether the provisions of the Income Tax Act and the Rules were correctly followed while determining the ALP.
Consequently, the present matter was remitted to the Karnataka High Court for consideration of the transfer pricing questions without relying upon the earlier observations in Softbrands.
The Revenue raised several questions concerning the approach adopted by the ITAT.
Among other issues, the Revenue questioned whether the Tribunal was justified in directing the TPO to consider only uncontrolled comparables having turnover between ₹1 crore and ₹200 crore. It also questioned whether the turnover filter could be applied without evidence establishing a correlation between turnover and profitability.
Another issue concerned whether the size and turnover of a company could be treated as relevant factors for determining whether it was comparable to the assessee.
The Revenue also challenged the exclusion of Bodhtree Consulting Ltd. as a comparable on the ground that it was functionally different from the assessee. Further, the Revenue questioned the Tribunal’s directions concerning working capital adjustment and the remand to the AO/TPO.
The Revenue did not press two other questions relating to tax deduction at source on leased-line charges and computation of deduction under Section 10A/10AA. The High Court therefore confined its consideration to the remaining questions.
On the first three questions, the High Court noted that the issues were covered by its decision in SAP Labs India Private Limited v. Income Tax Officer.
The Bench specifically observed that the size of a company is material for comparability and that a significant difference in turnover could affect transaction pricing.
Applying that reasoning to the present case, the Court noted that the ITAT had applied a turnover filter of ₹1 crore to ₹200 crore to ensure that companies identified from databases were of a similar size to the assessee.
The High Court consequently held that none of the first three questions raised by the Revenue could be regarded as a substantial question of law.
A major issue before the Court concerned the exclusion of Bodhtree Consulting Ltd. from the list of comparables.
The ITAT had excluded Bodhtree on the ground that it was also a product company, whereas the assessee was engaged only in software development services for its Associated Enterprise. The assessee did not own intellectual property and was not involved in developing or marketing software products.
The High Court noted that the ITAT had relied on its earlier decision in Cisco Systems India Private Limited v. DCIT, where Bodhtree’s functional profile had been examined. The Tribunal in that case had noted that Bodhtree was engaged in software products, open and end-to-end web solutions, software consultancy and software design and development.
The Court also considered the ITAT’s decision in Fiserv India Private Limited v. ITO, concerning the same assessment year. In that matter too, Bodhtree had been found to be not comparable to a company providing software development services because of its involvement in software product development.
The High Court referred in detail to the earlier reasoning adopted by the Tribunal in cases involving Bodhtree.
The Tribunal had noted that Bodhtree had a business profile involving technology incubation, product engineering, business intelligence, data management, consulting and other technology-related activities. It had also considered the company’s significant fluctuations in sales and profitability.
In one of the earlier cases, the Tribunal observed that the assessee was a software services company whereas Bodhtree was also engaged in software product development and segmental data was not available in the public domain. On that basis, Bodhtree was held to be functionally different and directed to be excluded from the comparables.
Another Tribunal decision in Cisco Systems similarly concluded that Bodhtree could not be treated as a comparable to a software development services company because of its software-product activities.
The Tribunal also held that the fact that the assessee itself had initially proposed Bodhtree as a comparable could not justify retaining it once it was factually established that Bodhtree was a software product company rather than a software development services company.
The High Court further recorded that the Revenue’s counsel fairly conceded that, considering the functional profile of Bodhtree, it could not be considered comparable to a pure captive software development company.
In view of the functional difference, the Court held that the fourth question raised by the Revenue did not constitute a substantial question of law.
The fifth question concerned the ITAT’s direction to remand the matter to the Assessing Officer/TPO for consideration in accordance with its observations.
The Revenue sought to contend that the determination of ALP should be undertaken afresh after the changes to the comparable set.
The High Court rejected this contention. It observed that the TPO had already determined a final set of comparables and that some of them were required to be excluded on the grounds identified by the ITAT. According to the Court, there was no requirement to conduct the entire exercise afresh when the comparability exercise had already been undertaken.
The Court therefore concluded that no substantial question of law arose on this issue either.
After examining the transfer pricing issues in light of the Supreme Court’s ruling in SAP Labs, the Karnataka High Court concluded that there was no error in the ITAT’s decision warranting interference under Section 260A of the Income Tax Act.
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