Assessee can Challenge the Inclusion of Comparable even If it Clears the Filters: Delhi HC [Read Judgment]

The High Court of Delhi, while upholding the ruling of Income Tax Appellate Tribunal (ITAT) held that since none of the comparables have been excluded on the ground of high turnover alone, the test of functional similarity applied by the Tribunal is in consonance with the legal position and resultantly, the assessee cannot be denied of the opportunity to challenge the inclusion of a comparable merely for the reason that it clears the filters.

The respondent-assessee, Open Solution Private Limited is engaged in the business of development of computer software and related services. It was set up in India as a separate entity to specifically provide software development, research, and other services to its AE. During the relevant previous year, the respondent had rendered services to its AE and declared its income and a book profit under section 115JB of the Income Tax Act. The assessee benchmarked the international transaction using the Transactional Net Margin Method (TNMM) and computed the Profit Level Indicator (PLI) of the international transaction at 11.87%. The assessee selected 14 comparable companies engaged in software development services and the arithmetic mean of the PLI was computed at 11.91%. The assessee declared that its profit margins were at arm’s length price (ALP) when compared to similarly situated companies.

The Tribunal undertook the FAR analysis i.e. examination of functions performed, assets employed and risks assumed as provided under Rule 10B(2) (b) of the Income Tax Rules and it directed the deletion of the four comparables in question.

Firstly, the Tribunal while considering the inclusion of Infosys Ltd., noted that the comparable is functionally different from the assessee company since it has a diversified profile. The asset profile of Infosys Ltd. consists of significant brand value and intangibles. It assumes the huge entrepreneurial risk, market risk, commercial risk, project liability risk, technology risk, and credit risk, whereas the assessee is risk mitigated captive service provider and therefore such a giant company cannot be compared with the assessee.

Secondly, while considering the inclusion of Wipro Technology Services Ltd., the tribunal deleted it since its transaction failed the Related Party Transaction (RPT) filter. It was held that the comparable had rendered services to the Citi Group as part of the pre-acquisition understanding, and, therefore, the revenue of the comparable is on account of related party transactions, making the company an unviable comparable.

Thirdly, while considering the inclusion of Persistent Systems Ltd, the Tribunal examined its Annual Report and observed that no segmental information is available, as to the revenue earned on account of software services and on account of sale of software products and in absence of such segmental information it could not be added as a comparable.

Lastly, while considering the inclusion of Thirdware Solutions and Sales Ltd. was deleted by the Tribunal since it was functionally dissimilar to the assessee company.

The division bench consisting of Justice Sanjeev Narula and Justice Vipin Sanghi upheld the decision of the ITAT and observed that none of the comparables have been excluded on the ground of high turnover alone. The test of functional similarity applied by the Tribunal is in consonance with the legal position.

“Only those comparables which are functionally similar to the assessee (tested party) and operate in a similar business environment as that of the assessee should be used for benchmarking to arrive at an accurate calculation of arm’s length price,” the bench said.

“It emerges that none of the comparables have been excluded on the ground of high turnover alone. The test of functional similarity applied by the Tribunal is in consonance with the legal position discussed hereinabove. Therefore, we do not find merit in the contentions urged by the Revenue on this ground. Equally meritless is the contention of the Revenue regarding the bar to challenge the comparables after the acceptance of the filters. The filters are applied to narrow down the search to find the comparables that are closest to the assessee. The use of filters has to be necessarily validated from the annual reports. Since the TPO would have to do this exercise on the basis of the actual data in the report of the comparables, he would surely have the freedom to adopt or reject the comparables. We cannot hold that merely because a comparable clear the filters, its inclusion in the list of comparables is immune to challenge by the assessee.”