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Rampgreen Solutions Pvt Ltd Vs. Commissioner Of Income Tax
August, 22nd 2015
$~
*      IN THE HIGH COURT OF DELHI AT NEW DELHI
10.
+                        ITA 102/2015
       RAMPGREEN SOLUTIONS PVT LTD            ..... Appellant
                   Through: Mr Ajay Vohra, Sr. Advocate with
                   Mr Aditya Vohra, Advocate.

                         versus

       COMMISSIONER OF INCOME TAX                ..... Respondent
                   Through: Ms Suruchi Aggarwal, Sr. Standing
                   Counsel with Ms Lakshmi, Jr. Standing Counsel.

       CORAM:
       HON'BLE DR. JUSTICE S.MURALIDHAR
       HON'BLE MR. JUSTICE VIBHU BAKHRU
                     ORDER
       %             10.08.2015

VIBHU BAKHRU, J.

1.     The Assessee has filed the present appeal under Section 260A of the

Income Tax Act, 1961 (hereafter `the Act') impugning the order dated 22 nd

March, 2013 passed by the Income Tax Appellate Tribunal (hereafter

`Tribunal') in ITA No. 6286/Del/2012. The Assessee had preferred the

aforesaid appeal before the Tribunal, impugning the assessment order passed

by the Assessing Officer (hereafter `AO') making the Transfer Pricing

Adjustments (hereafter `TP Adjustments') in respect of the As sessment Year

(hereafter `AY') 2008-09 as finalised by the Transfer Pricing Officer



ITA 102/2015                                                  Page 1 of 42
(hereafter `TPO') pursuant to the directions issued by the Dispute

Resolution Panel (hereafter `DRP').



2.     The Assessee is, essentially, aggrieved by the TP Adjustments made

in respect of the consideration for the services rendered by the Assessee to

its overseas holding company. The TP Adjustments have been made on the

basis of the average operating profit margin (operating profit as a percentage

of operating costs) declared by other companies ­ eight in number ­ selected

as comparables for the purposes of ascertaining the Arm's Length Price

(hereafter `ALP'). According to the Assessee, two of the companies chosen

as comparable by the concerned authority, namely, Vishal Information

Technology Ltd. (hereafter `Vishal') and eClerx Services Ltd. (hereafter

`eClerx') could not be considered as comparables as the functions performed

and the services rendered by the said companies were materially different

from those performed by the Assessee.


3.     This Court, by an order dated 27th February, 2015, admitted the

present appeal and framed the following questions of law:-

         "1. Did the ITAT fall into error in the given circumstances of
             the case in confirming the transfer pricing adjustment to
             the extent of Rs.5,92,07,428/- upholding the inclusion of




ITA 102/2015                                                     Page 2 of 42
               two comparable, i.e., e-Clerx Services Limited and
               Vishal Information Technologies Limited, now called as
               Coral Hub Ltd.?

         2.    Did the ITAT fall into error in not appreciating the terms
               of Rule l0B (2) of the Rules in respect of the analysis of
               functionally comparable companies?


4.     The factual context in which the aforesaid questions of law arise are

briefly stated as under:-



4.1    The Assessee is a wholly owned subsidiary of vCustomer, USA, (an

Associated Enterprise - hereafter `AE'). The Assessee is engaged in

providing voice-based customer care to the AE's clients. The Assessee

renders Call Center services, which fall within the broad description of

Information Technology Enables Services (hereafter `ITeS'). The Assessee

has two units registered under the Software Technology Park Scheme of the

Government of India, which are located at New Delhi and Pune. The

Assessee is remunerated for the voice call services on cost plus basis. The

Assessee explained that the AE undertakes all activities such as marketing

and enters into contracts with its customers seeking voice call services. The

AE bears all the business risks and the Assessee only acts as an offshore

service provider to the customers of the AE. In consideration for the




ITA 102/2015                                                      Page 3 of 42
services, the AE remunerates the Assessee by payment of all costs incurred

by the Assessee plus a mark up of fifteen percent of the costs.



4.2    During the previous year, relevant to the AY 2008-09, the Assessee

received an amount of Rs. 91,73,94,525/- for voice-based call center

services. The Assessee sought to justify the consideration received for the

international transactions entered into with the AE to be at ALP. The

Assessee submitted a Transfer Pricing Report adopting operating profit

margin as the Profit Level Indicator (hereafter `PLI') for the transfer pricing

studies. The Assessee applied the Transactional Net Margin Method

(hereafter `TNMM'), which was considered to be the most appropriate

method for the purposes of benchmarking the international transaction. The

Assessee's operating profit margin (i.e. operating profit/total cost) was

computed at 14.83% and the Assessee claimed that the same was

comparable with other companies rendering voice call services. For the

purposes of the transfer pricing study, the Assessee chose eight comparable

entities and the arithmetic average of the operating profit margins of the said

comparables was computed 15.74%. According to the Assessee, its PLI was

within the acceptable range as indicated under the second proviso to Section




ITA 102/2015                                                      Page 4 of 42
92C. The Assessee further claimed that the PLI was liable to be adjusted on

account of (i) working capital provided to the Assessee by the AE and (ii)

the risks of the business borne by the AE.






5.     The AO referred the matter to the TPO. The TPO, by an order dated

19th October, 2011, passed under section 92CA(3) of the Act, computed the

TP Adjustment at Rs. 11,00,35,400/- (Rupees Eleven Crore Thirty Five

Thousand and Four Hundred). The TPO accepted the method adopted by the

Assessee (i.e. TNMM), but rejected the benchmarking report. The TPO also

rejected the Assessee's claim for any adjustment on account of working

capital provided to the Assessee and/or risks borne by the AE. The TPO

proceeded to identify a different set of comparable companies for the

purposes of determining the ALP. The companies selected by the TPO

which were considered to be comparables included eClerx and Vishal

(subsequently known as Coral Hub Ltd.). The TPO computed the average

operating profit margin of the comparable companies at 28.96% on the basis

of the average operating profit margin of eleven companies selected by the

TPO as comparables for the purposes of benchmarking the international

transactions. On the aforesaid basis, the TPO computed the TP Adjustment




ITA 102/2015                                                  Page 5 of 42
at Rs. 11,00,35,400/-. The AO incorporated the aforesaid adjustment in the

draft assessment order passed under Section 144C(1) of the Act on 20th

December, 2011. The Assessee objected to the draft assessment order dated

20th December, 2011 before the DRP. The Assessee impugned the draft

assessment order on several grounds including selection of certain

companies as comparables and exclusion of other companies considered as

appropriate comparables by the Assessee.



6.     The DRP accepted the Assessee's contention with respect to certain

companies, which were considered as comparables by the TPO and directed

that the said companies be excluded for the purposes of determining the (i.e.

average operating profit margin). However, the Assessee's contentions with

regard to the exclusion of Vishal and eClerx were rejected by the DRP. The

DRP held that these companies were also providing Information Technology

Enabled Services (ITeS) and, thus, could be used as comparables. Insofar as

eClerx is concerned, the DRP held that although there were functional

dissimilarities, the same were not significant enough to warrant a rejection

of the said company as a comparable. With respect to Vishal, the DRP held

that the difference in business model of Vishal would not materially affect




ITA 102/2015                                                    Page 6 of 42
the profit margin and thus, there was no infirmity with the TPO's decision to

include the said company as a comparable in its report.



7.     The TPO recomputed the TP Adjustment in terms of the directions

issued by the DRP and computed the TP Adjustment at Rs. 5,92,07,428/-.

The AO also made certain additions on account of excess deduction claimed

under Section 10A of the Act and disallowance under Section 14A of the

Act.



8.     The Assessee appealed against the final assessment order dated 9 th

October, 2012, inter alia, on the ground that eClerx and Vishal could not be

considered as comparable entities for the purpose of calculating the

benchmark operating profit margin. The Assessee claimed that the said

companies were engaged in the business of Knowledge Process Outsourcing

(hereafter `KPO') and, thus, could not be included as comparables for the

purposes of benchmarking studies. According to the Assessee, although

KPO services were ITeS but the nature of the said services was materially

different from the services rendered by the Assessee. It was asserted that

eClerx is engaged in financial services in the nature of account




ITA 102/2015                                                    Page 7 of 42
reconciliation, trade order management services and has been rated as a

leading KPO by Nelso Hall. It was contended that similarly Vishal was

engaged in the services of data analytics and providing data processing

solutions to some of the largest brands in the world. Vishal too had been

rated as a leading KPO by Nelso Hall. In addition, it was pointed out that

whilst the employee costs incurred by Vishal was relatively low and

constituted only 4.39% of its total cost during the relevant year, the hire

charges, vendor payments constituted almost 87% of the total costs.

According to the Assessee, this evidenced that Vishal's business model was

different and Vishal had outsourced significant part of its operations.



9.     The Tribunal rejected the Assessee's contention and held that both

eClerx and Vishal were engaged in providing ITeS and once a service fell

within that category then no sub-classification of the segment was

permissible. The Tribunal held that KPO is a term given to the branch of

BPO Services where apart from processing of data, knowledge is also

applied. The Assessee's objection that the said two companies had

abnormally high profits and thus ought to be excluded as comparables was

also rejected.




ITA 102/2015                                                      Page 8 of 42
10.    The learned counsel for the Assessee submitted that eClerx and Vishal

were KPO service providers and could not be considered as comparables for

the purposes of benchmarking the Assessee's international transactions with

the AE. The learned counsel referred to the decision of the Special Bench of

the Tribunal in Maersk Global Centers (India) Pvt. Ltd. v. ACIT, ITA

7466/Mum/2012, dated 7th March, 2014 and submitted that the issue of

whether Vishal and eClerx could be used as comparables was decided in

favour of the Assessee.



11.    We have heard the counsel for the parties.


12.    At the outset, it is necessary to bear in mind that the object and

purpose of introducing provisions relating to transfer pricing adjustment in

the Act. By virtue of Finance Act, 2001, Section 92 of the Act was

substituted by Sections 92 to 92F of the Act with effect from 1 st April, 2002.

Section 92 of the Act, as was in force prior to 1 st April, 2002, enabled the

AO to bring the correct profits to tax in relation to certain cross-border

transactions. However, with a large number of multi-national companies

establishing operations in India, either through their subsidiaries or through

other related ventures, a need was felt to provide a statutory framework to




ITA 102/2015                                                     Page 9 of 42
ensure that there is no avoidance of tax by transfer of income from India to

other tax jurisdictions. Circular no. 14 of 2001 issued by the CBDT indicates

that the provisions of Section 92 to 92F of the Act were introduced "With a

view to provide a detailed statutory framework which can lead to

computation of reasonable, fair and equitable profits and tax in India".



13.    The heading of Chapter X also clearly indicates that it contains

"special provisions relating to avoidance of tax". The object of Chapter X

of the Act is not to tax any notional income but to ensure that the real

income is brought to tax under the Act. This has also been explained by a

Division Bench of this Court in Sony Ericsson Mobile Communications

India Pvt. Ltd. and Ors. v. Commissioner of Income Tax-III and Ors. 374

ITR 118 in the following words:-

         "77. As a concept and principle Chapter X does not
         artificially broaden, expand or deviate from the concept of
         "real income". "Real income", as held by the Supreme Court
         in Poona Electricity Supply Company Limited versus CIT, :
         [1965] 57 ITR 521 (SC), means profits arrived at on
         commercial principles, subject to the provisions of the Act.
         Profits and gains should be true and correct profits and gains,
         neither under nor over stated. Arm's length price seeks to
         correct distortion and shifting of profits to tax the actual
         income earned by a resident/domestic AE. The profit which
         would have accrued had arm's length conditions prevailed is
         brought to tax. Misreporting, if any, on account of non-arm's




ITA 102/2015                                                      Page 10 of 42
         length conditions resulting in lower profits, is corrected."


14.     The substratal rationale of the transfer pricing regulations is to ensure

that the true income of an Assessee is brought to tax under the Act and there

is no avoidance of tax by transfer of income from India to any other tax

jurisdiction by virtue of the influence exercised by the associated

enterprises. The aim of the provisions of Chapter X of the Act is to compute

the income in relation to a controlled transaction between an Assessee and

its associated enterprise having regard to ALP, in order to nullify the effect

of transfer of income to a jurisdiction outside India, if any, in respect of the

controlled transactions.



15.    The exercise of determining the ALP in respect of international

transactions between the related enterprises is aimed to determine the price,

which would have been charged for products and services, as nearly as

possible, in case such international transactions were not controlled by virtue

of them being executed between related parties. The object of the exercise

is, thus, to remove the effect of any influence on the prices or costs that may

have been exerted on account of the international transactions being entered

into between related parties. It is, at once, clear that for the exercise of




ITA 102/2015                                                       Page 11 of 42
determining ALP to be reliable, it is necessary that the controlled

transactions be compared with uncontrolled transactions which are similar in

all material aspects.



16.    We may now refer to the relevant provisions of Chapter X of the Act

keeping in view the aforesaid purpose and object of introducing the said

provisions in the Act.



17.    Section 92 of the Act provides that the income arising from an

international transaction would be computed having regard to the ALP. The

said section further provides for cost and expenses to be allocated and

apportioned between two or more associated enterprises with regard to ALP.



18.    Section 92C of the Act provides for provisions relating to

computation of ALP. Sub-section (1) of Section 92C of the Act provides for

the methods of computing the ALP and sub-section (2) of Section 92C of the

Act mandates that the most appropriate method that has been referred to in

Section 92C(1) be applied for determination of ALP. Sub-section (1) and

(2) of Section 92(C) of the Act reads as under:-




ITA 102/2015                                                   Page 12 of 42
       "92C. (1) The arm's length price in relation to an international
       transaction or specified domestic transaction shall be
       determined by any of the following methods, being the most
       appropriate method, having regard to the nature of transaction
       or class of transaction or class of associated persons or
       functions performed by such persons or such other relevant
       factors as the Board may prescribe, namely :--




       (a) comparable uncontrolled price method;

       (b) resale price method;
       (c) cost plus method;

       (d) profit split method;

       (e) transactional net margin method;
       (f) such other method as may be prescribed by the Board.

       (2) The most appropriate method referred to in sub-section (1)
       shall be applied, for determination of arm's length price, in the
       manner as may be prescribed:
       Provided that where more than one price is determined by the
       most appropriate method, the arm's length price shall be taken
       to be the arithmetical mean of such prices:
       Provided further that if the variation between the arm's length
       price so determined and price at which the international
       transaction or specified domestic transaction has actually been
       undertaken does not exceed such percentage not exceeding
       three per cent of the latter, as may be notified by the Central
       Government in the Official Gazette in this behalf, the price at
       which the international transaction or specified domestic
       transaction has actually been undertaken shall be deemed to be
       the arm's length price :

       Provided also that where more than one price is determined by
       the most appropriate method, the arm's length price in relation
       to an international transaction or specified domestic



ITA 102/2015                                                      Page 13 of 42
       transaction undertaken on or after the 1st day of April, 2014,
       shall be computed in such manner as may be prescribed and
       accordingly the first and second proviso shall not apply.

       Explanation.--For the removal of doubts, it is hereby clarified
       that the provisions of the second proviso shall also be
       applicable to all assessment or reassessment proceedings
       pending before an Assessing Officer as on the 1st day of
       October, 2009."


19.    It is also necessary to refer to Rule 10B of the Income Tax Rules,

1962 which provides for determination of ALP under Section 92C of the

Act. Sub-rule(1) of Rule 10B contains provisions in relation to various

methods of calculation of ALP as provided under Section 92C of the Act

and reads as under:-


         "10B. (1) For the purposes of sub-section (2) of section 92C,
         the arm's length price in relation to an international
         transaction or a specified domestic transaction shall be
         determined by any of the following methods, being the most
         appropriate method, in the following manner, namely :--
         (a) comparable uncontrolled price method, by which,--
               (i)    the price charged or paid for property transferred or
                      services provided in a comparable uncontrolled
                      transaction, or a number of such transactions, is
                      identified;
               (ii)   such price is adjusted to account for differences, if
                      any, between the international transaction or the
                      specified domestic transaction and the comparable
                      uncontrolled transactions or between the enterprises



ITA 102/2015                                                        Page 14 of 42
                      entering into such transactions, which             could
                      materially affect the price in the open market;
               (iii) the adjusted price arrived at under sub-clause (ii) is
                     taken to be an arm's length price in respect of the
                     property transferred or services provided in the
                     international transaction or the specified domestic
                     transaction;
         (b) resale price method, by which,--
               (i)    the price at which property purchased or services
                      obtained by the enterprise from an associated
                      enterprise is resold or are provided to an unrelated
                      enterprise, is identified;
               (ii)   such resale price is reduced by the amount of a
                      normal gross profit margin accruing to the enterprise
                      or to an unrelated enterprise from the purchase and
                      resale of the same or similar property or from
                      obtaining and providing the same or similar services,
                      in a comparable uncontrolled transaction, or a number
                      of such transactions;
               (iii) the price so arrived at is further reduced by the
                     expenses incurred by the enterprise in connection
                     with the purchase of property or obtaining of
                     services;
               (iv) the price so arrived at is adjusted to take into account
                    the functional and other differences, including
                    differences in accounting practices, if any, between
                    the international transaction or the specified domestic
                    transaction and     the     comparable      uncontrolled
                    transactions, or between the enterprises entering into
                    such transactions, which could materially affect the
                    amount of gross profit margin in the open market;




ITA 102/2015                                                            Page 15 of 42
               (v)    the adjusted price arrived at under sub-clause (iv) is
                      taken to be an arm's length price in respect of the
                      purchase of the property or obtaining of the services
                      by the enterprise from the associated enterprise;
         (c) cost plus method, by which,--
               (i)    the direct and indirect costs of production incurred by
                      the enterprise in respect of property transferred or
                      services provided to an associated enterprise, are
                      determined;
               (ii)   the amount of a normal gross profit mark-up to such
                      costs (computed according to the same accounting
                      norms) arising from the transfer or provision of the
                      same or similar property or services by the enterprise,
                      or by an unrelated enterprise, in a comparable
                      uncontrolled transaction, or a number of such
                      transactions, is determined;
               (iii) the normal gross profit mark-up referred to in sub-
                     clause (ii) is adjusted to take into account the
                     functional and other differences, if any, between the
                     international transaction or the specified domestic
                     transaction and the comparable uncontrolled
                     transactions, or between the enterprises entering into
                     such transactions, which could materially affect such
                     profit mark-up in the open market;
               (iv) the costs referred to in sub-clause (i) are increased by
                    the adjusted profit mark-up arrived at under sub-
                    clause (iii);
               (v)    the sum so arrived at is taken to be an arm's length
                      price in relation to the supply of the property or
                      provision of services by the enterprise;
         (d) profit split method, which may be applicable mainly in




ITA 102/2015                                                          Page 16 of 42
         international     transactions    or     specified  domestic
         transactions involving transfer of unique intangibles or in
         multiple international transactions or specified domestic
         transactions which are so interrelated that they cannot be
         evaluated separately for the purpose of determining the arm's
         length price of any one transaction, by which--
               (i)    the combined net profit of the associated
                      enterprises arising from the international
                      transaction or the specified domestic transaction in
                      which they are engaged, is determined;
               (ii)   the relative contribution made by each of the
                      associated enterprises to the earning of such
                      combined net profit, is then evaluated on the basis
                      of the functions performed, assets employed or to
                      be employed and risks assumed by each enterprise
                      and on the basis of reliable external market data
                      which indicates how such contribution would be
                      evaluated by unrelated enterprises performing
                      comparable functions in similar circumstances;
               (iii) the combined net profit is then split amongst the
                     enterprises in proportion to their relative
                     contributions, as evaluated under sub-clause (ii);
               (iv) the profit thus apportioned to the assessee is taken
                    into account to arrive at an arm's length price in
                    relation to the international transaction or the
                    specified domestic transaction:
         Provided that the combined net profit referred to in sub-clause
         (i) may, in the first instance, be partially allocated to each
         enterprise so as to provide it with a basic return appropriate for
         the type of international transaction or specified domestic
         transaction in which it is engaged, with reference to market
         returns achieved for similar types of transactions by
         independent enterprises, and thereafter, the residual net profit
         remaining after such allocation may be split amongst the



ITA 102/2015                                                       Page 17 of 42
         enterprises in proportion to their relative contribution in the
         manner specified under sub-clauses (ii) and (iii), and in such a
         case the aggregate of the net profit allocated to the enterprise
         in the first instance together with the residual net profit
         apportioned to that enterprise on the basis of its relative
         contribution shall be taken to be the net profit arising to that
         enterprise from the international transaction or the specified
         domestic transaction ;
         (e) transactional net margin method, by which,--
                (i) the net profit margin realised by the enterprise
                    from an international transaction or a specified
                    domestic transaction entered into with an
                    associated enterprise is computed in relation to
                    costs incurred or sales effected or assets employed
                    or to be employed by the enterprise or having
                    regard to any other relevant base;
                (ii) the net profit margin realised by the enterprise or
                     by an unrelated enterprise from a comparable
                     uncontrolled transaction or a number of such
                     transactions is computed having regard to the
                     same base;
                (iii) the net profit margin referred to in sub-clause (ii)
                      arising in comparable uncontrolled transactions is
                      adjusted to take into account the differences, if
                      any, between the international transaction or the
                      specified domestic transaction and the comparable
                      uncontrolled transactions, or between the
                      enterprises entering into such transactions, which
                      could materially affect the amount of net profit
                      margin in the open market;
                (iv) the net profit margin realised by the enterprise and
                     referred to in sub-clause (i) is established to be the




ITA 102/2015                                                       Page 18 of 42
                    same as the net profit margin referred to in sub-
                    clause (iii);
                (v) the net profit margin thus established is then taken
                    into account to arrive at an arm's length price in
                    relation to the international transaction or the
                    specified domestic transaction;
         (f) any other method as provided in rule 10AB."


For the purposes of the present case, clause (e) of sub-rule (1) of Rule 10B is

relevant as it pertains to determination of ALP by TNMM.



20.    In order for the benchmarking studies to be reliable for the purposes

of determining the ALP, it would be essential that the entities selected as

comparables are functionally similar and are subject to the similar business

environment and risks as the tested party. In order to impute an ALP to a

controlled transaction, it would be essential to ensure that the instances of

uncontrolled entities/transactions selected as comparables are similar in all

material aspects that have any bearing on the value or the profitability, as the

case may be, of the transaction. Any factor, which has an influence on the

PLI, would be material and it would be necessary to ensure that the

comparables are also equally subjected to the influence of such factors as the

tested party.   This would, obviously, include business environment; the




ITA 102/2015                                                      Page 19 of 42
nature and functions performed by the tested party and the comparable

entities; the value addition in respect of products and services provided by

parties; the business model; and the assets and resources employed. It cannot

be disputed that the functions performed by an entity would have a material

bearing on the value and profitability of the entity. It is, therefore, obvious

that the comparables selected and the tested party must be functionally

similar for ascertaining a reliable ALP by TNMM. Rule 10B(2) of the

Income Tax Rules, 1962 also clearly indicates that the comparability of

controlled transactions would be judged with reference to the factors as

indicated therein. Clause (a) and (b) of Rule 10B(2) expressly indicate that

the specific characteristics of the services provided and the functions

performed would be factors for considering the comparability of

uncontrolled transactions with controlled transactions.



21.    Rule 10B(2) reads as under:-

       "(2) For the purposes of sub-rule (1), the comparability of an
       international transaction or a specified domestic 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



ITA 102/2015                                                         Page 20 of 42
                     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."



22.    In the facts of the present case, it is not disputed that Vishal and

eClerx are entities engaged in Knowledge Process Outsourcing Services

(KPO Services). Thus, the principal question to be addressed is whether a

KPO Service provider could be considered as a comparable for

benchmarking international transactions entered into by an entity rendering

voice call services ­ such as the Assessee ­with its associated enterprise by

using TNMM and taking operating profit margin as the PLI .



23.    In this case, the Tribunal noted that eClerx was engaged in data

processing and analytics services and held that the activities of the Assessee




ITA 102/2015                                                        Page 21 of 42
were functionally similar to those of eClerx. The Tribunal concluded that

voice call services and KPO services were essentially ITeS and, therefore,

entities rendering the aforesaid services could be considered as comparables

for the purpose of benchmarking international transactions by using TNMM.

The Tribunal held that further sub-division of ITeS was not permissible. The

Tribunal followed its earlier decision in Willis Processing Services (I) (P.)

Ltd. v. Dy. CIT 30 ITR (Trib)129 (Mumbai) 2014.



24.    It is not disputed that voice call services are considered to be the

lower-end of ITeS. KPO on the other hand are ITeS where the service

providers have to employ advanced level of skills and knowledge.

Notification   No. SO2810(E) dated 18th September 2013 issued by the

CBDT notifying Safe Harbour Rules also indicates the above. Rule 10TA(g)

of the said Rules defines KPO Services as under:-


       " (g) "knowledge process outsourcing services" means
       the following business process outsourcing services
       provided mainly with the assistance or use of
       information technology requiring application of
       knowledge and advanced analytical and technical skills,
       namely:
       (i) geographic information system;
       (ii) human resources services;




ITA 102/2015                                                     Page 22 of 42
       (iii) engineering and design services;
       (iv) animation       or    content   development    and
       management;
       (v) business analytics;
       (vi) financial analytics; or
       (vii) market research,
       but does not include any research and development
       services whether or not in the nature of contract
       research and development services;"

25.    Whilst Voice Call Center represents the lower-end of ITeS, KPO

represents services involving a higher level of skills and knowledge. India

has vast human resources and a large number of highly-skilled technical

professionals. The expression "KPO" indicates the involvement of domain

knowledge in providing ITeS. Typically, KPO includes involvement of

advance skills; the services provided may include analytical services, market

research, legal research, engineering and design services, intellectual

management etc. On the other hand, Voice Call Centers are normally

involved in customer support and processing of routine data. In the case of

Maersk Global Centers (India) Pvt. Ltd. v. ACIT (supra) a Special Bench

of the Tribunal had referred to a report prepared by National Skill

Development Corporation (NSDC) on Human Resource and Skill

Requirements in IT and ITES Sector (2022) and noted that the KPO sector




ITA 102/2015                                                     Page 23 of 42
has been described as "a value play". The said report also indicates that

KPO services are likely to span activities such as "patent advisory, high -end

research and analytics, online market research and legal advisory".



26.    A Knowledge Process is understood as a high value added process

chain wherein the processes are dependent on advanced skills, domain

knowledge and the experience of the persons carrying on such processes.



27.    The     Government   of   Rajasthan    (Department    of   Information

Technology & Communication) has also floated a scheme on 12 th December,

2011 known as "The Rajasthan Incentive Scheme for BPO Centers and KPO

Centers, 2011". The said scheme is for providing incentives to promote ITeS

and to generate further employment opportunities. In terms of the said

scheme, "Business Process Outsourcing (BPO)" is defined to mean "the

transfer of an organization's entire non-core but critical business

process/function to an external centre which uses an IT-based service

delivery" and "Knowledge Processing Outsourcing (KPO)" has been

defined to mean "allocation of relatively high-level tasks to an outside

organization or a different group (possibly in a different location) within the




ITA 102/2015                                                      Page 24 of 42
same organization. KPO is, essentially, high-end Business Process

Outsourcing (BPO)".



28.    In our view, the definition of KPO provided under the afore-

mentioned scheme also indicates that KPO services are understood as the

higher-end of ITeS in terms of value addition.



29.    It is apparent from the above that while entities rendering Voice Call

Center services for customer support and a KPO service provider may be

employing IT-based delivery systems, the characteristics of services, the

functional aspects, business environment, risks and the quality of human

resource employed would be materially different. It plainly follows that

benchmarking international transactions on the basis of comparing the PLI

of high-end KPO service providers with the PLI of Voice Call Centers

would be unreliable and possibly flawed.



30.    As indicated above, in order to determine the ALP in relation to a

controlled transaction, the analysis must include comparables which are

similar in all aspects that have a material bearing on their profitability.




ITA 102/2015                                                    Page 25 of 42
Paragraph 1.36 of the "OECD Transfer Pricing Guidelines for Multinational

Enterprises and Tax Administrations" published in 2010 (hereafter `OECD

Guidelines') indicates the "comparability factors" which are important while

considering the comparability of uncontrolled transactions/entities with the

controlled transactions/entities. Sub-rule (2) of rule 10B of the Income Tax

Rules, 1962 also mandates that the comparability of international

transactions with uncontrolled transactions would be judged with reference

to the factors indicated under clauses (a) to (d) of that sub-rule, which are

similar to the comparability factors as indicated under the OECD

Guidelines. These include characteristics of property or services transferred

and functions performed. The relevant extract from the OECD Guidelines

are quoted below:

           "1.36 As noted above, in making these comparisons,
           material differences between the compared transactions
           or enterprises should be taken into account. In order to
           establish the degree of actual comparability and then to
           make appropriate adjustments to establish arm's length
           conditions (or a range thereof), it is necessary to compare
           attributes of the transactions or enterprises that would
           affect conditions in arm's length transactions. Attributes
           or "comparability factors" that may be important when
           determining comparability include the characteristics of
           the property or services transferred, the functions
           performed by the parties (taking into account assets used
           and risks assumed), the contractual terms, the economic
           circumstances of the parties, and the business strategies




ITA 102/2015                                                      Page 26 of 42
           pursued by the parties. These comparability factors are
           discussed in more detail at Section D.1.2 below.


           xxxx           xxxx          xxxx         xxxx
           1.39 Differences in the specific characteristics of property
           or services often account, at least in part, for differences
           in their value in the open market. Therefore, comparisons
           of these features may be useful in determining the
           comparability of controlled and uncontrolled transactions.
           Characteristics that may be important to consider include
           the following: in the case of transfers of tangible
           property, the physical features of the property, its quality
           and reliability, and the availability and volume of supply;
           in the case of the provision of services, the nature and
           extent of the services; and in the case of intangible
           property, the form of transaction (e.g. licensing or sale),
           the type of property (e.g. patent, trademark, or know-
           how), the duration and degree of protection, and the
           anticipated benefits from the use of the property.
           1.40 Depending on the transfer pricing method, this factor
           must be given more or less weight. Among the methods
           described at Chapter II of these Guidelines, the
           requirement for comparability of property or services is
           the strictest for the comparable uncontrolled price
           method. Under the comparable uncontrolled price
           method, any material difference in the characteristics of
           property or services can have an effect on the price and
           would require an appropriate adjustment to be considered
           (see in particular paragraph 2.15). Under the resale price
           method and cost plus method, some differences in the
           characteristics of property or services are less likely to
           have a material effect on the gross profit margin or mark-
           up on costs (see in particular paragraphs 2.23 and 2.41).
           Differences in the characteristics of property or services
           are also less sensitive in the case of the transactional
           profit methods than in the case of traditional transaction
           methods (see in particular paragraph 2.69). This however



ITA 102/2015                                                       Page 27 of 42
           does not mean that the question of comparability in
           characteristics of property or services can be ignored
           when applying these methods, because it may be that
           product differences entail or reflect different functions
           performed, assets used and/or risks assumed by the tested
           party. See paragraphs 3.18-3.19 for a discussion of the
           notion of tested party.
           1.41 In practice, it has been observed that comparability
           analyses for methods based on gross or net profit
           indicators often put more emphasis on functional
           similarities than on product similarities. Depending on the
           facts and circumstances of the case, it may be acceptable
           to broaden the scope of the comparability analysis to
           include uncontrolled transactions involving products that
           are different, but where similar functions are undertaken.
           However, the acceptance of such an approach depends on
           the effects that the product differences have on the
           reliability of the comparison and on whether or not more
           reliable data are available. Before broadening the search
           to include a larger number of potentially comparable
           uncontrolled transactions based on similar functions
           being undertaken, thought should be given to whether
           such transactions are likely to offer reliable comparables
           for the controlled transaction.
           D.1.2.2 Functional analysis
           1.42 In transactions between two independent enterprises,
           compensation usually will reflect the functions that each
           enterprise performs (taking into account assets used and
           risks assumed). Therefore, in determining whether
           controlled and uncontrolled transactions or entities are
           comparable, a functional analysis is necessary. This
           functional analysis seeks to identify and compare the
           economically significant activities and responsibilities
           undertaken, assets used and risks assumed by the parties
           to the transactions. For this purpose, it may be helpful to
           understand the structure and organisation of the group
           and how they influence the context in which the taxpayer



ITA 102/2015                                                      Page 28 of 42
           operates. It will also be relevant to determine the legal
           rights and obligations of the taxpayer in performing its
           functions.
           1.43 The functions that taxpayers and tax administrations
           might need to identify and compare include, e.g. design,
           manufacturing, assembling, research and development,
           servicing,     purchasing,      distribution,  marketing,
           advertising, transportation, financing and management.
           The principal functions performed by the party under
           examination should be identified. Adjustments should be
           made for any material differences from the functions
           undertaken by any independent enterprises with which
           that party is being compared. While one party may
           provide a large number of functions relative to that of the
           other party to the transaction, it is the economic
           significance of those functions in terms of their
           frequency, nature, and value to the respective parties to
           the transactions that is important.
           1.44 The functional analysis should consider the type of
           assets used, such as plant and equipment, the use of
           valuable intangibles, financial assets, etc., and the nature
           of the assets used, such as the age, market value, location,
           property right protections available, etc.
           1.45 Controlled and uncontrolled transactions and entities
           are not comparable if there are significant differences in
           the risks assumed for which appropriate adjustments
           cannot be made. Functional analysis is incomplete unless
           the material risks assumed by each party have been
           considered since the assumption or allocation of risks
           would influence the conditions of transactions between
           the associated enterprises. Usually, in the open market,
           the assumption of increased risk would also be
           compensated by an increase in the expected return,
           although the actual return may or may not increase
           depending on the degree to which the risks are actually
           realised.




ITA 102/2015                                                       Page 29 of 42
           1.46 The types of risks to consider include market risks,
           such as input cost and output price fluctuations; risks of
           loss associated with the investment in and use of
           property, plant, and equipment; risks of the success or
           failure of investment in research and development;
           financial risks such as those caused by currency exchange
           rate and interest rate variability; credit risks; and so forth.

                xxxx               xxxx          xxxx          xxxx
           1.51 In some cases, it has been argued that the relative
           lack of accuracy of the functional analysis of possible
           external comparables (as defined in paragraph 3.24)
           might be counterbalanced by the size of the sample of
           third party data; however quantity does not make up for
           poor quality of data in producing a sufficiently reliable
           analysis. See paragraphs 3.2, 3.38 and 3.46. "


31.    In the present case, the Tribunal noted that Vishal and eClerx were

both engaged in rendering ITeS. The Tribunal held that, "once a service

falls under the category of ITeS, then there is no sub-classification of

segment". Thus, according to the Tribunal, no differentiation could be made

between the entities rendering ITeS. We find it difficult to accept this view

as it is contrary to the fundamental rationale of determining ALP by

comparing controlled transactions/entities with similar uncontrolled

transactions/entities. ITeS encompasses a wide spectrum of services that use

Information Technology based delivery. Such services could include

rendering highly technical services by qualified technical personnel,



ITA 102/2015                                                          Page 30 of 42
involving advanced skills and knowledge, such as engineering, design and

support. While, on the other end of the spectrum ITeS would also include

voice-based call centers that render routine customer support for their

clients. Clearly, characteristics of the service rendered would be dissimilar.

Further, both service providers cannot be considered to be functionally

similar. Their business environment would be entirely different, the demand

and supply for the services would be different, the assets and capital

employed would differ, the competence required to operate the two services

would be different. Each of the aforesaid factors would have a material

bearing on the profitability of the two entities. Treating the said entities to

be comparables only for the reason that they use Information Technology for

the delivery of their services, would, in our opinion, be erroneous.



32.    It has been pointed out that whilst the Tribunal in Willis Processing

Services (India) Pvt. Ltd. v. DCIT (supra) held that no distinction could be

made between KPO and BPO service providers, however, a contrary view

had been taken by several benches of the Tribunal in other cases. In Capital

IQ Information System India (P.) Ltd. v. Dy. CIT, (IT) [2013] 32

taxmann.com 21 and Lloyds TSB Global Services Pvt. Ltd. v. DCIT, (ITA




ITA 102/2015                                                      Page 31 of 42
No. 5928/Mum/2012 dated 21th November 2012), the Hyderabad and

Mumbai Bench of the Tribunal respectively accepted the view that a BPO

service provider could not be compared with a KPO service provider.



33.    The Special Bench of the Tribunal in Maersk Global Centers (India)

Pvt. Ltd. (supra) struck a different cord. The Special Bench of the Tribunal

held that even though there appears to be a difference between BPO and

KPO Services, the line of difference is very thin. The Tribunal was of the

view that there could be a significant overlap in their activities and it may be

difficult to classify services strictly as falling under the category of either a

BPO or a KPO. The Tribunal also observed that one of the key success

factors of the BPO Industry is its ability to move up the value chain through

KPO service offering. For the aforesaid reasons, the Special Bench of the

Tribunal held that ITeS Services could not be bifurcated as BPO and KPO

Services for the purpose of comparability analysis in the first instance. The

Tribunal proceeded to hold that a relatively equal degree of comparability

can be achieved by selecting potential comparables on a broad functional

analysis at ITeS level and that the comparables so selected could be put to

further test by comparing specific functions performed in the international







ITA 102/2015                                                       Page 32 of 42
transactions with uncontrolled transactions to attain relatively equal degree

of comparability.



34.    We have reservations as to the Tribunal's aforesaid view in Maersk

Global Centers (India) Pvt. Ltd. (supra). As indicated above, the expression

`BPO' and `KPO' are, plainly, understood in the sense that whereas, BPO

does not necessarily involve advanced skills and knowledge; KPO, on the

other hand, would involve employment of advanced skills and knowledge

for providing services. Thus, the expression `KPO' in common parlance is

used to indicate an ITeS provider providing a completely different nature of

service than any other BPO service provider. A KPO service provider would

also be functionally different from other BPO service providers, inasmuch as

the responsibilities undertaken, the activities performed, the quality of

resources employed would be materially different. In the circumstances, we

are unable to agree that broadly ITeS sector can be used for selecting

comparables without making a conscious selection as to the quality and

nature of the content of services. Rule 10B(2)(a) of the Income Tax Rules,

1962 mandates that the comparability of controlled and uncontrolled

transactions be judged with reference to service/product characteristics. This




ITA 102/2015                                                     Page 33 of 42
factor cannot be undermined by using a broad classification of ITeS which

takes within its fold various types of services with completely different

content and value. Thus, where the tested party is not a KPO service

provider, an entity rendering KPO services cannot be considered as a

comparable for the purposes of Transfer Pricing analysis. The perception

that a BPO service provider may have the ability to move up the value chain

by offering KPO services cannot be a ground for assessing the transactions

relating to services rendered by the BPO service provider by benchmarking

it with the transactions of KPO services providers. The object is to ascertain

the ALP of the service rendered and not of a service (higher in value chain)

that may possibly be rendered subsequently.



35.    As pointed out by the Special Bench of the Tribunal in Maersk

Global Centers (India) Pvt. Ltd. (supra), there may be cases where an entity

may be rendering a mix of services some of which may be functionally

comparable to a KPO while other services may not. In such cases a

classification of BPO and KPO may not be feasible. Clearly, no straitjacket

formula can be applied. In cases where the categorization of services

rendered cannot be defined with certainty, it would be apposite to employ




ITA 102/2015                                                     Page 34 of 42
the broad functionality test and then exclude uncontrolled entities, which are

found to be materially dissimilar in aspects and features that have a bearing

on the profitability of those entities. However, where the controlled

transactions are clearly in the nature of lower-end ITeS such as Call Centers

etc. for rendering data processing not involving domain knowledge,

inclusion of any KPO service provider as a comparable would not be

warranted and the transfer pricing study must take that into account at the

threshold.



36.    As pointed out earlier, the transfer pricing analysis must serve the

broad object of benchmarking an international transaction for determining

an ALP. The methodology necessitates that the comparables must be similar

in material aspects. The comparability must be judged on factors such as

product/service characteristics, functions undertaken, assets used, risks

assumed. This is essential to ensure the efficacy of the exercise. There is

sufficient flexibility available within the statutory framework to ensure a fair

ALP.



37.    Applying the aforesaid principles to the facts of the present case, it is




ITA 102/2015                                                      Page 35 of 42
once again clear that both Vishal and eClerx could not be taken as

comparables for determining the ALP. Vishal and eClerx, both are into KPO

Services. In Maersk Global Centers (India) Pvt. Ltd. (supra), the Special

Bench of the Tribunal had noted that eClerx is engaged in data analytics,

data processing services, pricing analytics, bundling optimization, content

operation, sales and marketing support, product data management, revenue

management. In addition, eClerx also offered financial services such as

real-time capital markets, middle and back-office support, portfolio risk

management services and various critical data management services.

Clearly, the aforesaid services are not comparable with the services rendered

by the Assessee. Further, the functions undertaken (i.e. the activities

performed) are also not comparable with the Assessee. In our view, the

Tribunal erred in holding that the functions performed by the Assessee were

broadly similar to that of eClerx or Vishal. The operating margin of eClerx,

thus, could not be included to arrive at an ALP of controlled transactions,

which were materially different in its content and value. In Maersk Global

Centers (India) Pvt. Ltd. (supra), the Special Bench of the Tribunal had

noted the same and had, thus, excluded eClerx as a comparable. It is further

observed that the comparability of eClerx had also been examined by the




ITA 102/2015                                                    Page 36 of 42
Hyderabad Bench of the Tribunal in M/s Capital Iq Information Systems

(India) (P.) Ltd. v. Additional Commissioner of Income-tax (supra),

wherein, the Tribunal directed the exclusion of eClerx as a comparable for

the reason that it was engaged in providing KPO Services and further that it

had also returned supernormal profits.



38.    In our view, even Vishal could not be considered as a comparable, as

admittedly, its business model was completely different. Admittedly,

Vishal's expenditure on employment cost during the relevant period was a

small fraction of the proportionate cost incurred by the Assessee, apparently,

for the reason that most of its work was outsourced to other vendors/service

providers. The DRP and the Tribunal erred in brushing aside this vital

difference by observing that outsourcing was common in ITeS industry and

the same would not have a bearing on profitability. Plainly, a business

model where services are rendered by employing own employees and using

one's own infrastructure would have a different cost structure as compared

to a business model where services are outsourced. There was no material

for the Tribunal to conclude that the outsourcing of services by Vishal

would have no bearing on the profitability of the said entity.




ITA 102/2015                                                     Page 37 of 42
39.    It is also relevant to note that in the case of Maersk Global Centers

(India) Pvt. Ltd. (supra), the DRP itself had accepted the objection of the

Assessee and had excluded Vishal as a comparable for the reason as quoted

below:-

          "... that it had a very low employment cost and very high
          cost on account of venture payment, which suggested that its
          business model was that of an outsourcing company and in
          view of this functional difference, Vishal Ltd. could not be
          considered as a comparable."


40.    The Assessee had also sought the exclusion of eClerx and Vishal on

the ground that both the companies had returned supernormal profits.

Whereas the operating margins (operating margin over total cost) in case of

Vishal and eClerx were 50.68% and 65.88% respectively, the PLIs of all

other comparables were in the range of 2.2% to 24%. In our view, it would

not be apposite to exclude comparables only for the reason that their profits

are high, as the same is not provided for in the statutory framework. The

OECD Guidelines suggest that a quartile method be adopted which excludes

entities that fall in the extreme quartiles for comparability. However, neither

Chapter X of the Act nor the Rules made by CBDT provide for exclusion for

such statistical reason.




ITA 102/2015                                                      Page 38 of 42
41.    Having stated the same, it may be necessary to bear in mind that

supernormal profits may in certain cases indicate a functional dissimilarity

or dissimilarity with respect to a feature that has a material bearing on the

profitability. In such circumstances, it would be necessary to undertake

further analysis to eliminate the possibility of the high profits resulting on

account of any material dissimilarity between the tested party and the chosen

comparable. A wide deviation in the PLI amongst selected comparables

could be indicative that the comparables selected are either materially

dissimilar or the data used is not reliable. The Tribunal proceeded on the

basis that an adjustment could be made only in cases where supernormal

profits resulted from the factors indicated in Rule 10B of the Income Tax

Rules, 1962. In our view, the factors mentioned in Rule 10B are not

exhaustive. The principal object of benchmarking international transactions

against uncontrolled transactions is to impute an ALP to those transactions.

This exercise would fail if a factor, which has a material bearing on the

value or the profitability, as the case may be, depending on the method used,

is ignored.



42.    Before concluding, there is yet another aspect of the matter that needs




ITA 102/2015                                                     Page 39 of 42
consideration. The Tribunal proceeded on the basis that while applying

TNMM method, broad functionality is sufficient and it is not necessary that

further effort be taken to find a comparable entity rendering services of

similar characteristics as the tested entity.    The DRP held that TNMM

allows flexibility and tolerance in selection of comparables, as functional

dissimilarities are subsumed at net margin levels, as compared to Resale

Price Method or Comparable Uncontrolled Price Method and, therefore, the

functional dissimilarities pointed out by the Assessee did not warrant

rejection of eClerx and Vishal as comparables.



43.    In our view, the aforesaid approach would not be apposite. Insofar as

identifying comparable transactions/entities is concerned, the same would

not differ irrespective of the transfer pricing method adopted. In other

words, the comparable transactions/entities must be selected on the basis of

similarity with the controlled transaction/entity. Comparability of controlled

and uncontrolled transactions has to be judged, inter alia, with reference to

comparability factors as indicated under rule 10B(2) of the Income Tax

Rules, 1962. Comparability analysis by TNMM method may be less

sensitive to certain dissimilarities between the tested party and the




ITA 102/2015                                                     Page 40 of 42
comparables. However, that cannot be the consideration for diluting the

standards of selecting comparable transactions/entities. A higher product

and functional similarity would strengthen the efficacy of the method in

ascertaining a reliable ALP. Therefore, as far as possible, the comparables

must be selected keeping in view the comparability factors as specified.

Wide deviations in PLI must trigger further investigations/analysis.


44.    Consideration for a transaction would reflect the functions performed,

the significant activities undertaken, the assets or resources used/consumed,

the risks assumed. Thus, comparison of activities undertaken/functions

performed is important for determining the comparability between

controlled and uncontrolled transactions/entity. It would not be apposite to

ignore functional dissimilarity only for the reason that its impact may be

reduced on account of using arithmetical mean of the PLI. The DRP had

noted that eClerx was functionally dissimilar, but ignored the same relying

on an assumption that the functional dissimilarity would be subsumed in the

profit margin. As noted, the content of services provided by the Assessee

and the entities in question were not similar. In addition, there were also

functional dissimilarities between the Assessee and the two entities in

question. In our view, these comparability factors could not be ignored by




ITA 102/2015                                                    Page 41 of 42
the Tribunal. While using TNMM, the search for comparables may be

broadened by including comparables offering services/products which are

not entirely similar to the controlled transaction/entity. However, this can be

done only if (a) the functions performed by the tested party and the selected

comparable entity are similar including the assets used and the risks

assumed; and (b) the difference in services/products offered has no material

bearing on the profitability.



45.    In view of the aforesaid, the questions of law framed by an order

dated 27th February, 2015 are answered in the affirmative and against the

Revenue. The impugned order dated 22nd March, 2013 of the Tribunal and

the final assessment order dated 9th October, 2012 are hereby set aside. The

appeal is allowed.



                                                    VIBHU BAKHRU, J




                                                    S. MURALIDHAR, J

AUGUST 10, 2015
RK




ITA 102/2015                                                      Page 42 of 42

 
 
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