The Law On Use Of Secret Comparables In Transfer Pricing

In the present paper, I propose to deal with some of the cases decided in India in last couple of years by High Courts and Income Tax Tribunal on the issue which I am expected to deal, namely, the comparability of secret comparables by TPO while determining ALP.
I should inform you, the fellow members, that there are very few decided & reported cases yet from higher appellate & Constitutional Courts like Supreme Court of India at Delhi and 24 High Courts, from one of which, Rajasthan High Court, Jodhpur from where I come.
  But there are quite a large number of cases decided by Income Tax Tribunal, which has 40 Benches with 80 members strength in our country and the said Tribunal, being the final fact finding authority under the Income Tax Act, 1961, these cases which I would discuss now, throw considerable light on the issue.

2. Ethics of Secret Comparables

Comparability analysis looks can be a laborious, difficult, time-consuming and, more often than not, costly exercise. Collecting information, analyzing all the data from various sources, documenting the analysis which Tax Advisories or Government appointed bodies do and income adjustments are all steps that require time and money. The aim should be to ensure that the compliance burden and costs borne by a taxpayer to identify possible comparables and obtain detailed information thereon are reasonable and proportionate to the complexity of the transaction. But that alone cannot be a reason for the dilution of comparability, permissible in theory.

Taxpayers and tax administrations should exercise fair judgment to determine whether particular comparables are reliable or not.

In my submission, allowing of income adjustments by determining ALP with comparison with secret comparables or cherry picking is not a very a healthy assessment practice. The principles of natural justice, fair play and equity does not permit such practices even in tax jurisprudence. But it appears that with changing times, borderless trade, software technology and human ingenuity helping tax evasion may justify this & with even legislative prescriptions & permissiveness, this concept may gain the status of an established practice. The data bank of tax administrators has gradually increased to a level and with constant pouring in of such information in public domain & secretively both, the development of law will take place. Of course, the assessee company or PE of MNE is given the opportunity to rebut such comparability with other ALPs but the tug of war between tax payer and tax gatherer in this regard generally ends in favour of tax gatherer and the cost of litigation for the tax payer to establish his credibility of declared price or income is generally a negative factor.

That is why we the tax Judges in such Conferences like the 4th Congress of IATJ should discuss and guide the Tax Administrations worldwide for a more healthy, congenial and uniform system of tax assessments in the perspective of international trade, tax laws and double taxation avoidance treaties under OECD model law and UN Model laws, which also do not favour use of secret comparables, without allowing an opportunity to tax payer to distinguish or rebut those comparables.

Developed countries, such as the US & UK have an official policy of not using secret comparables. In Australia and Netherlands, where we have all assembled, under specific judicial pronouncements, secret comparables are not allowed. However, a few other countries such as Japan, France, China, Germany and India permit use of secret comparables. Mexico specifically allows such use.

In Japan, the latest legal position as per site of TPA Global, as per the requirements under Article 22-10(1) of the Enforcement Regulation for the Special Taxation Measures Law, if the taxpayers are unable to provide those documents in a timely manner upon request at the time of transfer pricing tax audit, they can trigger the tax examiner’s authority to collect transactional data from comparable independent firms to use as a “secret comparable” for the taxpayer. The information that may be requested by the NTA includes details of capital relationships, inter-company transactions, business activities, financial performance, method selection, search process and comparables selected.

Where the tested party is located in Japan, there is a requirement for comparables from the Japanese market. Detailed information and data on Japanese companies is available from a number of Japanese and regional financial databases, such as ORBIS etc. from Bureau van Dijk. There is a risk that secret comparables may be used in cases where the taxpayers do not prepare transfer pricing documentation.

The Paris Court of Appeal ruled in favour of Nestle in the case of Nestle’s French subsidiary, Nestle Enterprises against the Minister of Economy and Finances (case no. 12PA00469) in relation to the use of secret comparables as per the French Tax Code article 57.

As per French Tax Code article 57, the tax authorities are allowed to use secret comparables in assessing the arm’s length range of a taxpayer. In this case, the French tax authorities have used comparable cash pooling operations of three major groups listed on the French Stock Exchange. The arm’s length compensation has been set at 0.5% on the borrowed amount of the cash pool at the end of the previous three financial years. As a result, the tax authorities performed adjustments to the tax base of the corporate income tax rate of 2002, plus the relevant penalties and interests.

Nevertheless, the court of appeal ruled that the tax authorities failed to use a valid comparable due to the fact that the three major groups were selected without any indication of the company names, terms and conditions of the cash pool agreements and if the guarantee of the selected comparables are comparable to Nestle Enterprises. Therefore, court of appeal considered that secret comparables cannot be used as per article 57.

Recently, in India, the Organization of Pharmaceutical Producers of India (OPPI) proposed a restriction on use of secret comparables by TPAs in Budget 2013. The Pharmaceutical industry is closely governed by Patent Law and their financial data are closely related to the production of their patented products and, therefore, analysis of secret comparables in their case, on the one side has great revenue fetching scope and on the other side misuse of secret comparables at the same time.

Some Jurist rightly & aptly said, “While death & taxes, both are inevitable, being taxed to death is not”. Yet another saner sense pronounced, “The tax collection from subjects should be like collection of honey from the bees – gradual & drop by drop”. How true it is these days – is for all of us to ponder.

3. Some Decided Cases of High Courts of India.

• DELHI HIGH COURT DECISIONS

3.1 Commissioner of Income Tax Vs. Mentor Graphics (Noida) Pvt. Ltd. [2013] 215 Taxman 539 (Delhi) Decided on 4th April 2013.

On a question that, “Whether, in view of the first proviso to section 92C(2) of the Income Tax Act, 1961, the Tribunal was correct in holding that if one profit level indicator of a comparable, out of a set of comparables, is lower than the profit level indicator of the taxpayer, then the transactions reported by the taxpayer is at an arm’s length price as contemplated in sections 92, 92C and other related provisions of the said Act”.?

The Division bench of Delhi High Court in its recent pronouncement of 4th April 2013 in Commissioner of Income Tax Vs. Mentor Graphics (Noida) Pvt. Ltd. 2013 IV AD (Delhi) 477, [2013] 354 ITR 586(Delhi), [2013] 215 TAXMAN 539(Delhi) has held that

“On an examination of TPO’s order, it is apparent that the general grounds for rejection of the comparables submitted by the assessee were as under:-
(a) The companies suggested by the assessee were actually not comparable in as much as their turnovers were widely different;
(b) The assessee had not used the data of the financial year ending 31.03.2002 which was the relevant year for the purposes of determination of the arm’s length price;
(c) The assessee did not include companies in its list of comparables which had a different product profile. According to the TPO, companies having different product profiles also ought to have been included in as much as the TNMM method for arriving at the arm’s length price allowed for functional differences, which included differences in product profiles;
(d) The comparable companies suggested by the assessee were not companies involved in chip design software; and
(e) The companies having a high ratio of trading activity had not been excluded by the assessee from its list of comparables.
We find that while these were the general reasons cited by the TPO for rejecting the comparables suggested by the assessee, the TPO had not indicated as to how each of the comparables suggested by the assessee did not fulfill the criteria which was adopted by him. The TPO suggested that the following filters should have been employed while searching out the comparables:-
(1) Companies engaged in software development having annual turnovers between Rs.50 lakhs and Rs.100 crores;
(2) Companies whose employees’ cost is more than 10% of the turnover;
(3) Companies whose sales from manufacturing and trading does not exceed 10% of the total sales; and
(4) Companies which do not have any related party transactions.
Based upon the said filters, the TPO conducted his own search from the ‘PROWESS’ and ‘CAPITALINE’ DATABASES and the NASSCOM DIRECTORY and short listed seven companies”.

The Court concluded that;

“The sum and substance of the Tribunal’s order is that the criteria adopted by the TPO for searching comparables was not correct. Secondly, the TPO had not specifically rejected any of the comparables of the assessee. The Tribunal was of the view that the comparables of the assessee ought to have been accepted and, had that been the case, there would have been no need for the TPO to search for comparables. Of course, in passing the order, the Tribunal made certain general observations that unless and until the comparables drawn by the tax payer were rejected, a fresh search by the TPO could not be conducted. However, this has to be tempered with the relevant statutory provisions which are clearly set out in sub-section (3) of section 92C of the said Act which stipulates four situations where under the TPO may proceed to determine the arm’s length price in relation to an international transaction. If any one of those four conditions are satisfied, it would be open to the TPO to proceed to determine the ALP. This clarification of the observation of the Tribunal was necessary and that is why we have done so.
We also note that the Tribunal had gone further and reduced the list of comparables to merely four as indicated in the impugned order. We do not think that it was the right approach to be adopted by the Tribunal. The Tribunal should have stopped at the point where it decided on facts that the comparables given by the assessee were to be accepted and those searched by the TPO were to be rejected. The only option then left to the Tribunal was to derive the arithmetical mean of the profit level indicators of the comparables which were accepted by it. In this case such comparables happen to be those of the assessee.
The Tribunal, in selecting only one profit level indicator out of a set of profit level indicators had clearly erred in law. However, in the facts of the present case that would not make any difference to the assessee’s case in as much as even if the arithmetical mean of the comparables as accepted by the Tribunal are taken into account, the profit level indicator would, whether the seven companies are taken into consideration or all eight companies are taken into consideration, be less than 6.99% which is the profit level indicator of the assessee for the relevant year, that is, financial year ending 31.03.2002.
We may also make it clear that the reference to the OECD guidelines by the Tribunal in the impugned order are in the context of the reliance placed by the TPO on the very same guidelines, in particular, to paragraph 3.27 thereof (see Appendix 1). In the present case, there are specific provisions of sub-rules (2) and (3) of Rule 10B of the said Rules as also of the first proviso to section 92C(2) of the said Act which apply (see Appendix 3). Therefore, the question of applying OECD guidelines does not arise at all.
From the foregoing discussion, it is clear that the Tribunal was wrong in holding that if one profit level indicator of a comparable, out of a set of comparables, is lower than the profit level indicator of the taxpayer, then the transaction reported by the taxpayer is at an arm’s length price. The proviso to section 92C(2) is explicit that where more than one price is determined by most appropriate method, the ALP shall be taken to be the arithmetical mean of such prices. To this extent the appeal is allowed. However, as pointed out above, if this principle is applied to the comparables suggested by the assessee (which have not been rejected by the TPO), the ALP suggested by the assessee would yet be acceptable in law.”

3.2 Moser Baer India Ltd. V. ADDL CIT (2008) TS 9 HC Del Decided on 19th Dec. 2008



Delhi High Court in another case of Moser Baer India Ltd. V. Addl CIT (2008) TS 9 HC Del. held that sec. 92CA (3) of Income Tax Act casts an obligation on the TPO to afford a personal hearing to the assesse before passing an order determining ALP. The requirement of granting an oral hearing was ‘mandatory’ and could not be given a ‘short shrift’ by the TPO. HC observed that the TPO must give an option to the assessee, by issuing a show cause notice, to inspect the material available (presumably material including secret comparables available, which are sought to be used as yardstick against the assessee ) with the TPO , furnish additional evidence, if the assesse so desired and seek personal hearing.

Thus while collection of secret comparables by TPO is not banned in law, use of the same against the assessee company without putting it to him with sufficient opportunity to rebut the same is not mandated by law, nor it is legally permissible.

• Bombay High Court Decisions

3.3 CIT VS. Carlyle India Advisors (P.) Ltd. [2013] 214 TAXMAN 4 (Bom), Decided on 22 Feb. 2013

On the questions

a) Whether on the facts and circumstances of the case, the Tribunal was correct in holding that comparable selected by the TPO were not functionally comparable while determining ALP?

(b) Whether on the facts and circumstances of the case, the Tribunal was correct in allowing safe harbor margin of 5% to the assessee?

The Bombay High Court Division Bench 22 Feb. 2013 in the case of CIT Vs. Carlyle India Advisors (P.) Ltd. [2013] 214 TAXMAN 492(Bom) held that

“The basic dispute is the determination of Arms Length Price (ALP) in respect of investment advisory and related support services by the respondent-assessee to its Associated Enterprises (AE) in Hong Kong. It is undisputed that the Transaction Net Margin Method (TNMM) is the most appropriate method for determining the ALP. There was one comparable viz. M/s. IDC (India) Limited which was common between the Revenue and the assessee. However, eight more comparables were relied upon by the Revenue. On the basis of the mean so determined, the TPO concluded that the difference was in excess of 5% variables and, therefore, the ALP determined by the respondent-assessee was not accepted. The Tribunal by the impugned order held that the eight comparables other than M/s. IDC (India) Limited were not functionally comparable with the assessee and, therefore, could not be relied upon. The counsel for the Revenue states that for the subsequent assessment years, assessing officer himself has found that the eight comparables selected by the TPO were not functionally comparable with the respondent for determining the ALP. Moreover, in the impugned order the Tribunal has in detail pointed out why the selected comparables are not proper and failure of the assessing officer to consider the objections of the assessee. In this view of the matter, we see no reason to entertain question (a) as framed(as they are not substantial question of law on which an appeal lies before High Court as per Sec. 260 A of the Act).
Insofar as question (b) is concerned, it becomes academic as if the eight comparables selected by the TPO are found not to be functionally comparable then the difference between the operating margin of the respondent at 15.05% as against the 18.97% of comparable companies being within the range of +/- 5% the amounts received by the assessee is within the statutory limits.”

3.4 Mitsui O.S.K. Lines Maritime (India) (P.) Ltd Vs.:Deputy Commissioner of Income Tax-8(2) Mumbai[2012] 209 Taxman 151(Bom), Decided on 17 July 2012

In case of Mitsui O.S.K. Lines Maritime (India) (P.) Ltd Vs.:Deputy Commissioner of Income Tax-8(2) Mumbai [2012] 209 TAXMAN 151(Bom), dated 17/7/2012, considering the ITAT order, the Bombay High Court held as under : -

“In effect, the TPO and the AO ignored certain comparables including under the agreement on the ground that they pertain to loss making/ continuously loss making organizations. The appellant however contended that it was necessary to consider a variety of entities, both loss making and otherwise. The appellant disputed the approach on the one hand excluding the loss making entities but considering the entities that had abnormally high profits.
Although the order of ITAT very fairly permits the appellant an opportunity of filing fresh comparables for the financial Year 2002-2003 in order to enable the appellant to make out its case properly, the appellant is willing to proceed before the Tribunal on the basis of the existing material including the comparables already furnished. It states that it does not wish to furnish any further material.
In that event no purpose would be served by remanding the matter to the AO or for that matter, even before the CIT(A) for a fresh decision on the existing material. The AO and CIT(A) have already decided the same. The Tribunal has not held that it is not possible to arrive at the ALP on the basis of the existing material. The Tribunal must therefore now decide the matter. We wish to clarify that the power of the Tribunal in all respects is kept open and that the statement on behalf of the assessee does not affect the same.”

4. Some Decided Cases from Income Tax Tribunal, India

4.1 Trilogy E-Business Software India Ltd VS. DCIT (2013) 140 ITD 540, Decided on 23 Nov. 2012

Dealing with a case of applying filter for selection of comparables in the case of Software development services & differentiability between Onsite & Offshore provisions of such services, the Bangalore Bench of ITAT in its recent decision of 23 Nov. 2012 in Trilogy E-Business Software India Ltd Vs. DCIT (2013) 140 ITD 540, held as under : -

“The crux of the relevant Rules in 10 B of Income Tax Rules 1982, in so far as it relates to the contentions regarding application of the Onsite revenue filter, is that comparability of an international transaction with an uncontrolled transaction shall be judged with reference to the following, namely:–
(a) the specific characteristics of the property transferred or services provided in either transaction;
(b) the functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to the transactions;
(c) the contractual terms (whether or not such terms are formal or in writing) of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions;
(d) conditions prevailing in the markets in which the respective parties to the transactions operate, including the geographical location and size of the markets, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition and whether the markets are wholesale or retail.
It is only when there are no difference between the uncontrolled transaction and the international transaction as set out above or if there are differences but such difference will not affect the price or cost charged or paid or profit arising from such transactions or if there will be differences in price or cost charged or pair or profit arising from such transactions, such differences should be reasonably capable of being quantified and adjustment made to eliminate the effect of such differences.
The Indian software sector provides both on-site and offshore services. The Assessee in the present case is mainly offshore service provider and it generates income only from offshore software development service. Most of the uncontrolled enterprises follow hybrid model with revenue mix both from onsite and offshore. It is true that in terms of the functions performed both in the case of offshore service provider and onsite service provider, it is development of computer software. But having regard to Rule 10B(2)(b) it is necessary to have regard to the functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to the transactions.
It is no doubt true that in TNMM it is only the margins in an uncontrolled transaction that is tested with reference to the controlled transaction but it is not possible to ignore the fact that pricing will have an effect on the margins obtained in a transaction. The argument that if pricing structure were to be considered as criteria, then it will have to be seen as to what is the pricing structure of all the comparable for various projects cannot be accepted because the TPO has not chosen any other onsite software service provider with a revenue composition of more than 75% from onsite software services as comparable. As rightly observed by the TPO, the pricing is different in onsite when compared to offshore operations. The further observations of the TPO that the reasons for the same lie in the fact that while in the case of OFFSHORE projects most of the costs are incurred in India; an ONSITE project has to be carried out abroad significantly increasing the employee cost and other costs.
The companies who generate more than 75% of the export revenues from onsite operations outside India are effectively companies working outside India having their own geographical markets, cost of labour etc., and also return commensurate with the economic conditions in those countries. Thus assets and risk profile, pricing as well as prevailing market conditions are different in predominantly onsite companies from predominantly offshore companies like the taxpayer. Since, the entire operations of the tax payer are taking place offshore i.e. in India; it is but natural that it should be compared with companies with major operations offshore, due to the reason that the economics and profitability of onsite operations are different from that of offshore business model. As already stated the Assessee has limited its analysis only to functions but not to the assets, risks as well as prevailing market conditions in which both the buyer and seller of services located. Hence, the companies in which more than 75% of their export revenues come from onsite operations are to be excluded from the comparability study as they are not functioning in similar economic circumstances to that of the tax payer. Hence, it is held that this filter is appropriately applied by the TPO.
M/s. Indium India Ltd., a comparable considered by the Assessee in its TP study was rejected by the TPO as not comparable on the ground that the said company was rendering software testing services. It is the plea of the assessee that software testing is an integral part of software development cycle. It is further pointed out that the TPO in his analysis has selected Ishir Infotech Ltd., which renders software testing activities as comparable. This contention of the Assessee is not correct. According to the TPO’s order, the objection of the Assessee for selecting Ishir Info Tech Ltd. as comparable is for the reason that this company was outsourcing software development and that the company does not satisfy 25% employee cost filter. Both these objections have been found to be not sustainable by the TPO. The question therefore would be as to whether software testing services would be equivalent to software development services. Software testing is only part of software development life cycle. It cannot be equated with software development services. The TPO in our view rightly excluded this company for comparability purposes.”

Upholding the right of TPO to collect information from Secret Comparables, the Tribunal further held that,

“We are of the view that the TPO in the case of this company has not used information u/s. 133(6) of the Act and therefore the Assessee can have no grievance. If on the other hand the Assessee wants to show that information available in public domain is not correct then the onus would be on the Assessee to establish the same. The Assessee cannot ask for a right to cross examine on a surmise that the information given in response to notice u/s. 133(6) of the Act would be correct and that given in the annual report is incorrect. The Assessee if he is able to show prima facie that the information available in public domain is incorrect then we will be persuaded to afford opportunity to the Assessee but not on a claim which lacks substance and is based on surmises.
The comparable now accepted as comparable and their operating margins before and after working capital adjustment are detailed in the table given below:-
Table 1-Turnover Range 1 To 200 Crores And After Considering Comparables Selected By The Assessee

Sl. No.	Name of the Company	Operating Revenues	Operating Margin on Cost	Adjusted Margin on Cost
1	Datamatics Ltd.	545,088,027	1.38%	0.58%
2	E-Zest Solution Ltd.	62,594,544	36.12%	37.23%
3	Geometric Ltd. (seg)	1,583,797,773	10.71%	10.81%
4	Helios & Matheson Information technology Ltd.	1,786,380,304	36.63%	35.62%
5	Ishir Infotech Ltd.	74,209,887	30.12%	31.60%
6	LGS Global Ltd. (Lanco Global Solutions Ltd.)	453,893,898	15.75%	16.36%
7	Lucid Software Ltd.	16,992,078	19.37%	18.24%
8	Mediasoft Solutions Pvt. Ltd.	18,508,785	3.66%	2.77%
9	Megasoft Ltd (Seg.)	637,132,545	23.11%	17.85%
10	Quintegra Solutions Ltd.	627,216,924	12.56%	10.42%
11	R S Software (India) Ltd.	1,010,449,441	13.47%	14.33%
12	R Systems International Ltd. (Seg)	1,120,172,651	15.07%	14.44%
13	SIP Technologies & Exports Ltd.	37,980,955	13.90%	11.90%
14	Thirdware Solutions Ltd. (Seg)	360,850,000	25.12%	22.71%
	Arithmetic Mean			17.508%

The differential between the margins of the assessee as above and of the comparable in the Table given above, is beyond the 5% range. Applying, the proviso to section 92C(2), adjustment is required to be made to the reported values of the assesee’s transactions with its associated enterprises. The AO is directed to make adjustment to the ALP adopting the arithmetic mean of 17.508% and consequent addition to the total income.”

4.2 Adaptec India Pvt. Ltd. Vs. DCIT (2013) 154 TTJ 129

In Adaptec (India Pvt. Ltd Vs. DCIT (2013) 154 TTJ 129, Hyderabad Bench of Tribunal in its decision of 31st Jan. 2013 applying Turnover filter, excluded comparables with extremely high turnover, even though functionally similar entities by observing that ,

“Undisputedly assessee is a service provider operating with limited or no risk at all. Whereas both Infosys and Wipro are considered as giants in the sector of software development assuming all the risks, it is accepted principle that more the risk more is the profit. The dynamics of these companies also cannot be compared with the assessee. While the turnover of the assessee is about 15 crores only, the turnovers of Infosys and Wipro are Rs. 13149 crores and Rs. 9616 crores respectively. When the TPO has applied the turnover filter by excluding companies having turnover of less than Rs. 1 crore, he should have applied the same logic to exclude companies having extraordinarily high turnover compared to the assessee. So far as learned Departmental Representative’s contention that the assessee itself has selected Infosys as a comparable is concerned, there is merit in the contention of the learned AR that the TPO cannot adopt a pick and choose method while selecting comparables, when he has rejected the entire TP study report of the assessee. Therefore IT & W cannot be taken as comparables in the case of assesse. Accordingly, the AO is directed to recompute the ALP after excluding IT & W as comparables.”

4.3 Genisys Integrating Systems (India) P. Ltd. Vs. Dy. CIT

(2013 ) 152 TTJ 215 (Bangalore Bench)

The Tribunal in a case decided on 5th August, 2011 the Tribunal upheld collection of secret comparables by TPO u/s 133(6) of the Act but emphasized the need of putting them to assessee and allowing him to cross examine such comparables.

Brief Facts:

The brief facts of the case are that the assessee is a company which is engaged in the business of providing software development and IT enabled services. It is part of M/s Genisys Group. The assessee exports its services to its AE and also other clients. For the year under consideration, a return of income was filed by the assessee declaring a total of income of Rs.81,75,080/-. During assessment proceedings u/s 143(3), it was also noticed that the assessee has received payments from its AE clients for providing the software development services and also IT enabled services exceeding Rs.15 Crores. In view of the same, a reference was made to the TPO u/s 92CA of the IT Act for determination of ALP of the international transaction. The TPO issued initial notice asking the assessee to furnish the documents required to be maintained u/s 92D and the same was furnished by the assessee. The TPO also issued notice relating to determination of ALP for Software Development Services and also with regard to the Information Technology Enabled Services (ITES in short). These notices contained remarks on assessee’s study, new search methodology adopted for selecting the comparables, new comparables selected by the TPO and copies of replies received u/s 133(6) from these other companies. The assessee filed a detailed reply for both the notices and also raised various objections to the comparables selected by the TPO. The TPO however, was not convinced by these objections and made adjustments u/s 92CA of the Income-tax Act, by making the following observations:

(a) The assessee extends software development services and also extends its information technology enabled services to M/s Genesis MNC, which in turn helps its US customers through all the stages of the product life cycle i.e from visualization to post launch support. M/s Genesis has extensive experience in developing and supporting the Microsoft technology including SQL Server and related tools. It also has offshore development centre. In order to arrive at the ALP for the international transactions, the assessee, after making the search on the prowess and capitaline data bases, has selected 15 comparables for the software development services and had adopted the TNMM (Transactional Net Margin Method) as the most appropriate method for arriving at the ALP.

The assessee applied the following filters for finalizing the 15 comparables.

1) Companies for which sufficient financial data was not available to undertake analysis

2) Selection of companies having sales turnover of more than 1 crore and less than 200 crores;

3) Elimination of companies having export sales less than 25% of their total revenues

4) Elimination of companies which are functionally different

5) Companies which have been making persistent operating losses;

6) Companies that had substantial (excess of 25%) transactions with related parties;

7) Companies that had exceptional years of operation.

(b) After applying the above filters, the assessee arrived at 15 comparables with an average profit margin of 6.36% on cost. As the margin earned by the assessee was 6.61% i.e more than the adjusted mean margin, the assessee submitted that price charged by it in international transaction of software development services is to be treated as being at arm’s length. The TPO, however held that the companies engaged in software development services were treated by the assessee as comparables irrespective of the verticals of software. She held that the assessee is mostly an offshore software development provider i.e akin to software development service provider and derives 100% of its Revenue from export services to its AE in US. She held that the filters adopted by the assessee for arriving at the 15 comparables have several defects.

Contentions of Assessee

The TPO himself has rejected the companies which are making losses as comparables. This shows that there is a limit for the lower end for identifying the comparables. In such a situation, we are unable to understand as to why there should not be an upper limit also. What should be upper limit is another factor to be considered. We agree with the contention of the learned counsel for the assessee that the size matters in business. A big company would be in a position to bargain the price and also attract more customers. It would also have a broad base of skilled employees who are able to give better output. A small company may not have these benefits and therefore, the turnover also would come down reducing profit margin. Thus, as held by the various benches of the Tribunal, when companies which are loss making are excluded from comparables, then the super profit making companies should also be excluded. For the purpose of classification of companies on the basis of net sales or turnover, a reasonable classification has to be made. Dun & Bradstreet and NASSCOM have given different ranges. Taking the Indian scenario into consideration, the classification made by Dun & Bradstreet is more suitable and reasonable. In view of the same, the turnover filter is very important and the companies having a turnover of Rs.1.00 core to 200 crores have to be taken as a particular range and the assessee being in that range having turnover of 8.15 crores, the companies which also have turnover of 1.00 to 200.00 crores only should be taken into consideration for the purpose of making TP study.

Contention that the provision of sec.92D and Rule-10D is defeated if, the TPO takes the data which is available in the public domain after the specified date and the ALP would be fluid and there would be no certainty for the same is not sustainable. The ALP has to be determined by the TPO in accordance with law and the Act provides that the TPO shall take into consideration the contemporaneous data. The assessee is only required to maintain the information and documents as may be necessary relating to the international transactions so that it can be made available to the TPO or the AO or any other authority in any proceedings under the Act

Decision of Tribunal

When he is making the search for a relevant comparable, the TPO can issue notices to the parties whom he considers as relevant to gather requisite information and on being satisfied with regard to relevancy of the material which can be used against the assessee only then the assessee has to be given an opportunity of presenting its objections. Thus, the TPO need not inform the assessee about the process used by him for issuing the notices u/s 133(6) nor is he under any obligation to furnish the entire information to the assessee.

If any information is sought to be used against the assessee, the same has to be furnished to the assessee and thereafter, taking into consideration the assessee’s objections, if any, only then can the TPO proceed to take a decision. If the assessee seeks an opportunity to cross examine the party, the assessee shall be provided such an opportunity. It is only during a cross examination that the assessee can rebut the stand of that particular company. The assessee has also brought out various defects in the additional comparables selected by the TPO and has brought out the glaring differences between the functions of those comparables as compared to assessee and also as to how the entire revenue of the assessee has been taken into consideration inspite of there being income from unrelated party transactions also.

When companies which are loss making are excluded from comparables, then super profit making companies should also be excluded; for the purpose of classification of the companies on the basis of net sales or turnover, a reasonable classification has to be made:

(a) The operating revenue and the operating cost of the transactions relating to associated enterprises only shall be considered;

(b) The comparables having the turnover of more than 1.00 crore but less than 200.00 crores only shall be taken into consideration;

(c) All the information relating to comparables which are sought to be used against the assessee shall be furnished to the assessee;

(d) The assessee shall be given an opportunity of cross examining the parties whose replies are sought to be used against the assessee if the assessee so desires;

(e) To consider the objections of the assessee that relate to additional comparables sought to be adopted by the TPO and pass a detailed order and

(f) To give the standard deduction of 5% under the proviso to sec.92C (2) of the Act.

4.4 Kodiak Networks (India) P.Ltd. v. ACIT (2013) 152 TTJ 98 (Bangalore Bench)

In Kodiak Networks (India) P.Ltd. v. ACIT (2013) 152 TTJ 98, the same bench of ITAT in its decision rendered on 27 Jan. 2012, following its earlier view in Genysis case above, emphasized the need of limiting the selection of secret comparables in a range near the business volume of the assesse in source state and also to use the contemporaneous data of such comparables.

Brief Facts

The assessee is an Indian Company, a subsidiary of Kodiak Networks Inc., USA. It is engaged in the business of software development service to Kodiak Networks Inc, USA. The return of income for concerned asst. year was filed on 28/11/2006 declaring an income of Rs. 11,97,597/-. During the year, the assessee company had the following international transactions with its Associate Enterprise (i) rendering of software development services; (ii) marketing and customer support services; (iii) purchase of capital goods; (iv) sale of capital goods; and (v) reimbursement of expenses.

The appellant rendered software development services wholly to its AE. The total value of software development service was Rs. 24,06,82,087/. The appellant adopted Transactional Net Margin Method (TNMM) to justify the price charged in the international transactions. The appellant conducted a methodical search process on Prowess database to identify comparable companies. After adopting various search filters, the appellant selected 49 companies as comparables. The arithmetic mean of these comparables was 11.01%. The appellant’s operating margin on cost was 10.70%. Since the appellant’s margin of 11.01% was within the 5% range as provided in proviso to s. 92C (2), it was concluded that the international transactions relating to software development services are at arm’s length.

The Tribunal held that the turnover of the company is in the range of 24 crores, therefore, the companies, which have turnover of Rs. 1.00 crores to 200 crores alone should be taken into consideration for the purpose of making TP study. In these circumstances, this issue requires to be remitted back to the file of the TPO for fresh consideration with the directions that the operating revenue and the operating cost of the transactions relating to associated enterprises only shall be considered.

Emphasising the need to use contemporaneous date, the bench said that ALP has to be determined by the TPO by taking into consideration contemporaneous data relevant to the previous year in which the transaction has taken place and he is not restricted from using the information available in public domain beyond any cut-off date; though the TPO is not any obligation to furnish the entire information to the assessee, when any information is sought to be used against the assessee, it has to be given a reasonable opportunity of hearing on that material; TPO having not considered various defects pointed out by the assessee in the selection of additional comparables by the TPO and other infirmities in the computation of ALP, matter is remitted back to the TPO for fresh consideration with specific directions.

However, upholding the collection of data from secret comparables units, the bench studied the provisions of sec. 92 F and Rule 10 D and held that the Act has not provided for any cut-off date upto which only the information available in public domain has to be taken into consideration by the TPO, while making TP adjustments and arriving at ALP. The Tribunal thus upheld his powers by saying that when the TPO is making the search for a relevant comparable, he can issue notices to the parties whom he considers as relevant to gather requisite information and on being satisfied with regard to relevancy of the material which can be used against the assessee only then the assessee has to be given an opportunity of presenting its objections, if any. Thus, the TPO need not inform the assessee about the process used by him for issuing the notices u/s 133(6) of the Act nor is he under any obligation to furnish the entire information to the assessee.

4.5 Intervet India P Ltd. Vs. ACIT (2010) 130 TTJ 301

In Intervet India P Ltd. Vs. ACIT (2010) 130 TTJ 301, Mumbai. Bench of Tribunal in its decision of 31st March 2010 emphasized that vast disparate economic conditions of Thailand & Vietnam could not be ignored merely on account of geographical proximity & suitable adjustment made for only volume discount, credit offered & credit risk was not sufficient & thus remanding the case back , the Tribunal held that,

“While it is conceded that when there is a sale of identical product to an unrelated party, it will form the basis of determining the ALP in respect of sales to an AE, but one of the essential prerequisites is that reasonably accurate adjustments are to be made to eliminate material factors affecting price, cost or the profit arising from such transaction. But at least all material factors should be considered in arriving at the adjustments. The TPO and the CIT(A) have assumed similarity of markets and economic conditions and have made adjustments only for the volume discount, credit offered and a small adjustment of credit risk. They have completely ignored the disparate economic and market conditions of Thailand and Vietnam and have made no adjustment for the same. Mere geographical contiguity of two countries need not mean similarity in economic or market conditions. How can the sale prices to wholesale agents in two different countries be comparable, when the sale price to the final user in one country is less than the sale price to the wholesale agent in another country, unless adjustment for the same has been considered. Thus the adjustments merely for volume off take, credit period and credit risk, though material, are not sufficient to make the sale price to AE in Thailand comparable with the sale to unrelated party in Vietnam. Scope of adjustments has to be widened and all the submissions of the assessee regarding the disparity between the two transactions should be considered and suitable adjustments made for the same. With the above directions the issue is set aside to the file of the learned CIT(A) for deciding the matter afresh after giving reasonable opportunity to the assessee to present their case.”

4.6 Philips Software Centre P Ltd Vs. ACIT (2008) 119 TTJ 721

In one of the rather earlier but detailed analysis of TP provisions, Bangalore Bench of ITAT in its decision dated 26th Sep. 2008 in the case of Philips Software Centre P Ltd, Vs. ACIT (2008) 119 TTJ 721 held as under : -

“The Act and the Rules provide that while conducting the comparability analysis, the data to be used should be contemporaneous. In this regard, the requirement of law is two-fold: (a) Data to be used for analyzing the comparability of an uncontrolled transaction shall be the data relating to the financial year in which the international transaction has been entered into (Rule 10B(4)3; and (b) Amongst other things, the data which is used for the comparability analysis should exist latest by the specified date (Rule 10D(4)). Accordingly for the purpose of conducting the comparability analysis, the data should : (a) relate to the relevant financial year if the provision to R. 10B(4) is not attracted]; (b) exist by the specified date. It should be noted that both the conditions are cumulative in nature. If any one condition is not satisfied, the relevant comparable ought not to be included in the comparability analysis.
In the TP study conducted by the assessee, the database used for conducting the comparability analysis was Capitaline 2000 (‘Capitaline’). The said database is compiled by Capital Market Publishers India Ltd. and is a comprehensive interactive database of around 7,000 Indian companies, covering all companies listed on major stock exchanges like BSE/NSE plus other big unlisted companies. However, for the purpose of concluding the transfer pricing assessment, the TPO used another database (i.e., Prowess). The TPO did not: (a) question the database used by the assessee; (b) question the data which emanated from such database; (c) specifically reject the database used by the assessee; and (d) provide any reason for using the new database. There was no infirmity in the TP study conducted by the assesse and the TPO erred in disregarding the same for the purpose of framing the assessment and making the transfer pricing adjustment.
In theory, the comparability analysis in a transfer pricing documentation can be conducted either by cherry picking companies and considering them as comparables or starting with a set of all companies which are potentially comparables and following a methodical approach for eliminating non-comparable companies to leave a final set of comparables, consistent with the criteria used for elimination. The assessee has conducted a TP study using the second approach. The TPO has resorted to pick and choose. In the TP study conducted by the assessee, comparable companies were arrived at after using a methodical search process on the Capitaline database. For the purpose of conducting the comparability analysis on Capitaline, the assessee selected all companies in the computer software industry, as the first step. The said search process was followed by applying a number of pre-defined filters, both quantitative (i.e., system based) and qualitative (i.e., manual based) Alters/eliminations. Thus, the final comparable companies were those which survived the elimination process and not the companies which were selected by the assessee. The final set of comparable companies were in accordance with the criterion mentioned in Rule 10B(2). It would also be relevant to note that the transfer pricing guidelines for MNE’s and tax administrations issued by the OECD lays down the following five factors which should be considered for conducting a comparability analysis. The said five factors which are very similar to the provisions of R. 10B(2), are as follows : (i) characteristics of property or services; (ii) functional analysis; (iii) contractual terms; (iv) economic circumstances; and (v) business strategies. From the above it is clear that the focus is on the functions performed and the reference to other economic criterion is only in the context of the functions. It would also be relevant to note that in the order, the TPO has admitted that the comparables are functionally similar. However even after admitting that the comparables in the TP study are functionally similar to the assesse, the TPO has rejected the comparables in the TP study. The onus was on the TPO/AO to state and to show that the range of the turnover sizes chosen by the assesse was wrong.
As it is clear from R. 10A(a),for the purpose of comparability analysis, the comparables should not be having transactions with its AE. In other words, a company having any related party transactions (i.e., even a single rupee of related party transaction) should not be considered as a comparable company. The above view is also supported by the OECD.”

DOMESTIC RESTRICTIONS AGAINST DISCLOSURE OF INFORMATION RELATING TO ASSESSEE NOT IN PUBLIC DOMAIN

In India the restriction or confidentiality of assessee’s data under Income Tax law are contained in Sec. 137 (since omitted by the Finance Act, 1964, with effect from 1st April, 1964) & Sec. 138 of the Income Tax Act of 1961. The Supreme Court of India dealt with these provisions as discussed below. However it may be noted that the special provisions for TP assessments of international transactions to determine ALP were enacted later in the year 2001.

In Dagi Ram Pindi Lall (1992) 2 SCC 13, the Supreme court upheld the powers of civil court to summon Income Tax record of an assessee as an evidence but the Commissioner of Income Tax could claim privilege & subject to its determination by Civil Court itself. The Court said that,

“The repeal of Section 137 of the Act clearly discloses the legislative intent that it was felt by the legislature that it was no more necessary to keep the records of assessment by the Income Tax Department relating to an assessee as confidential from the courts and the bar with regard to the production of any part of the record was removed in so far as the courts are concerned. The finality which has been attached to the order of the Commissioner under Section138(1)b of the Act is, thus, restricted to the cases where the information etc. as contemplated by the Section is called for by any person, other than a court of law by a judicial order. The Commissioner of Income Tax under this Clause performs only an administrative function, on his subjective satisfaction as to whether it is in the public interest to furnish the information or not to any person seeking such information and his decision in that behalf is final and the aggrieved person cannot question it in a court of law. By enacting this provision, the legislature could not be said to have intended that the Commissioner of Income Tax would have the authority to sit in judgment over the requisition made by a court of law requiring the production of record of assessment relating to an assessee in a case pending before the court. When a court of law, in any matter pending before it desires the production of record relating to any assessment after applying its judicial mind and hearing the parties and on being prima facie satisfied that the record required to be summoned is relevant for the decision of the controversy before it passes a judicial order summoning the production of that record from the party having possession of the record. The Commissioner of Income Tax cannot, therefore, refuse to send the record, as he certainly is not authorised to set at naught a judicial order of a court of law. He must obey the order of the court by sending the record to the court concerned. Indeed, it is open to the Commissioner of Income Tax to claim privilege, in respect of any document or record so summoned by a court of law, under Sections 123 and 124 of the Indian Evidence Act 1872 and even then it is for the court to decide whether or not to grant that privilege.”

Recently the Supreme Court in Girish Ramchandra Deshpande Vs. CIC (2013) 1 SCC 12 in its Judgment dated 3/10/2012 rejected such disclosure to “any person” under Right to Information Act 2005 holding that

“The details disclosed by a person in his income tax returns are "personal information" which stand exempted from disclosure under Clause (j) of Section8(1) of the RTI Act, unless it involves a larger public interest and the Central Public Information Officer or the State Public Information Officer or the Appellate Authority is satisfied that the larger public interest justifies the disclosure of such information, appropriate orders could be passed but the petitioner cannot claim those details as a matter of right.”

However such restrictions would not prevent TPO to summon such information from any assessee under sec. 131 & sec. 133(6) of the Act which clothes the TPO with the powers of Civil Court. But such information collected has to be used very objectively & wisely to avoid loss of privacy & disclosure of information of competitors & leak it inadvertently into the public domain.

CONCLUSIONS

(i) The selection of secret comparables is permissible under TP provisions In Indian Tax Laws but their application to the case of tax payer has to be done subject to restriction in domestic law against disclosure of information not in public domain to the tax payer & after following procedure relating to giving of opportunity of hearing, cross examination of material & witnesses, adjustment for differentials of competitive entities & allowing standard deviation or permissible deviation of ALP of 5% of arithmetical mean of profit level of compared entities. In my submission the said deviation margin of 5% not attracting any income adjustment, deserves to be increased to atleast 10% because 5% margin is too narrow to jack up the declared ALP of international transactions of the tax payer. It will avoid time consuming & costly litigation & hair splitting exercise by tax administrations & tax payers.. However, in India this margin has been further reduced to 3% by Parliament while extending the applicability of these provisions to Specific Domestic Transactions also in 2012 by amending sec. 92C proviso by Income Tax (Amendment) Act, 2011 w.e.f. 1st April 2013. This deserves to be reviewed & increased to 10% as suggested above.

(ii) While disclosing the data of secret comparables to the tax payer entity, the TPO should take an Undertaking from it that information with respect to third party will not be divulged by it to any other person nor the same will be used against the interest of such disclosed entity (competitors) otherwise it should be made punishable offense.

(iii) TPO should use data of comparables of contemporary period & the comparables should not be functionally different from the tax payer or else suitable adjustments should be made for such functional differences, if any.