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2007-TIOL-382-ITAT-DEL
(Also see analysis of the Order )
IN THE INCOME TAX APPELLATE TRIBUNAL

DELHI BENCH 'H'
ITA NO. 1969/D/2006

Asstt. Year : 2002-03
MENTOR GRAPHICS (NOIDA) PVT LTD
Vs
Dy COMMISSIONER OF INCOME TAX
Shri Vimal Gandhi, President &

R C Sharma, Accountant Member
Dated : November 2, 2007
Appellant Rep. by : Shri Pawan Kumar and Shayamal Mukherhjee

Respondent Rep. by : Shri Himalini Kashyap
Income Tax - Transfer Pricing - Assessee exclusively develops software for its parent
company in the USA on order and the same is used alongwith others in the components used
in the harware products sold in the open market - Also provides marketing systems services -
Determination of Arm's Length Price (ALP) - Assessee does detailed due diligence to arrive at
ALP - AO refers it to the TPO who in turn recommends rejection of the comparables decided
by the assessee and makes alternate suggestions - AO makes additions and CIT(A) upholds it
- TPO cannot summarily reject the detailed analysis done by the assessee to choose the
comparabales and pick up arbitrary parametres to select comparables and also pick up
certain paras of the OECD guidelines to peddle the cause of TNMM and ignore the mandatory
section and rules of the domestic laws - Too many errors in the method applied by the TPO
and the additions made cannot be sustained - Assessee's appeal allowed
ORDER
Per : Shri Vimal Gandhi, President :
This appeal by the taxpayer for the Asstt. Year 2002-03 (F.A.2001-02) is directed against the
order of Commissioner of Income Tax (Appeals) [in short CIT (A)] New Delhi dated 3.3.2006.
The main dispute pertains to adjustment/addition of INR 1,45,73,857 in the income of the
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taxpayer by the revenue authorities on account of determination of arm's length price (ALP)
for software services provided to its Associated Enterprises (AE). The deduction claimed by
the taxpayer u/s 10A of the Income Tax Act but denied by the tax authorities is also subject
matter of dispute in appeal.2. The facts in short compass, the taxpayer, a domestic company
incorporated on Feb. 27, 1998 under the Indian Companies Act is the wholly owned
subsidiary of IKOS Systems Inc., a company incorporated in USA and engaged in the
business of software development and also rendering marketing systems services to the
parent company. The taxpayer filed its return of income for the year under consideration on
October 31, 2002 declaring total income at INR 3,99,080/- for the F.A. 2001-02. The income
disclosed included profit from export of computer software to its parent company for which
deduction u/s 10A was claimed.2.1 The taxpayer appellant as noted earlier is a software
development support service provider. However, software are developed only as instructed
by its parent AE. It does not create/develop/sell software products and packages. The
software developed by the appellant is used by the parent AE in-house for integrating the
same with other software components developed by the parent AE itself. The whole software
in turn supports the hardware manufactured by the parent, and sold as a package in the
open market by the parent AE. Therefore the appellant's business is limited to providing
services of software development support.
3. The accounts and auditor's report of the taxpayer showed that the taxpayer had carried
the following transaction with its associated enterprises (AEs):-
Sl. No.
Book value of
International
the
Transactions (IT)
International
with IKOS
transactions
SYSTEMS USA
1. Export of Software 88,866,320
Development
Services
2. Export of 3,436,194
Marketing Support
Services
4. The taxpayer in order to show that transactions with AEs were arm's length transactions
selected Transactional Net Margin Method (TNMM) as the most appropriate method under
Section 92C of the Income Tax Act and further justified the price charged for services as
arm's length price with following certificate in the auditor's report:-
"Based on the study, the arithmetic mean of three year weighted average
margins for financial years ended March 31, 2000, March 31, 2001 and March 31,
2002 to the extent available of broadly comparable independent companies
calculated using Net Cost Plus Margin as the profit level indicator was compared
by the assessee with its three year weighted average margin for financial years
March 31, 2000, March 31, 2001 and March 31, 2002. In the opinion of the
assessee its Net Cost Plus Margin, having regard to economic and commercial
factors, appears to be arm's length as provided under section 92C of the Act.
Accordingly, the amounts received/receivable in respect of the above transactions
have been computed by the assessee having regard to the arm's length price."
5. The Assessing Officer referred the question of computation of Arm's length price of
international transactions to Transfer Pricing Officer (TPO). The TPO accepted that export of
marketing support services have been rendered at the arm's length price and, therefore, the
amount disclosed by the assessee as per books needed no adjustment. In the above
situation, we thought it appropriate not to make any comment on the transaction relating to
export marketing support services. The discussion hereafter is confined to other transaction
of export of software development services.6. Export of software development services, has
been shown at total value at INR 88,866,320 for the entire year. Taxpayer has further
explained that software was supplied by the taxpayer to its parent company and price was
worked out at the rate of US$ 180 per man day. The transactions were priced on average
and should have been compared with either an internal comparable, uncontrolled price
(internal CUP) or an external comparable uncontrolled price (external CUP). The parent
company did not receive similar services from any independent third party, nor the taxpayer
provided such services to any uncontrolled party and, therefore, internal CUP did not exist.
Even external CUP was not available. Average billing rates (man days/man month rate)
would vary from technology to technology, from one domain to another and differ according
to hierarchy levels, contractual terms, market conditions, geographies and it would not be
possible to make adjustment for above factors as also for economic conditions. Above all, all
the relevant information is not available in public domain. Therefore, in the circumstances
and situation mentioned above, average bill rate, according to the taxpayer was the correct
representation of a CUP. The taxpayer having regard to the above worked out net margin of
software development transaction INR 88,866,320 (total turnover of Rs. 9,23,02514) in ratio
of total cost at 6.99%.7. In order to show that above net margin was fair and reasonable and
represented arm's length price, the taxpayer claimed it has taken the following steps. It
carried its own functional, asset and risk (FAR) analysis and of several other independent
companies carrying on business of development of software. The taxpayer was taken as the
tested party. In its written submissions the taxpayer further claimed as under:-
"Based on the functional analysis and understanding of the international

transactions with associated enterprises and the available data of comparable
companies, the Transactional Net Margin Method (TNMM) using net profit margin
based on costs (NCP) as a profit level indicator (PLI). was selected to be the most
appropriate transfer pricing method to evaluate these transactions.12.12. On the
question of Search for comparable companies (Refer para 4.1.4. page no. 89 to
93 of the paper book, the taxpayer submitted as under:-The objective of the
search for comparable companies was to identify from publicly available data, a
group of independent companies that undertake software development just as
the appellant company.The PROWESS contains financial data of over eight
thousand largely publicly traded Indian companies. The idea is collected from
annual/quarterly results, government reports and other sources.The search under
this database was structured to cover the 'Company's Main Activity' as well as
Products Manufactured/traded etc.'. All the companies classified under the
following categories were considered: - Computer software ; and - Software
service and consultancy.
This search yielded a list of 373 companies."
8. Thereafter, the taxpayer carried quantitative screening and eliminated 32 companies as

their manufacturing sales to sales ratio was more than 25%. Further, 82 companies were
eliminated as trading sales to sales ratio was more than 25%. This was done as the taxpayer
is only engaged in provision of services and is not engaged in any manufacturing or trading
activity. The description of the search relating to eliminating of above 114 companies is
available at pages 113 to 115 of the paper book. The taxpayer thereafter performed a
qualitative review of remaining 259 companies. From product profile, director's report,
background information and financial statements, taxpayer tried to find companies having
similar functional profile to that of taxpayer. On above screening, the assessee eliminated
249 companies as those companies were dealing with different product or were carrying
different functions or were involved in controlled party transactions or sale of operation was
very low or suffered operational loss of more than 10%. In respect of some, insufficient
information was available in public domain regarding their products, functions or financial
position. The reasons for elimination of 243 companies are available at page 9 of the paper
book filed by the taxpayer.
9. The taxpayer was thereafter left with 16 companies with profit level indicator for financial
years 2000 and 2001:-
S. Name of the
2000 2001
No. Company
1.Top Media
(12.12)
Entertainment9.68
2.Kushagra
0.0
Software (0.56)
3.Shine
5.16
Computech 3.69
4.M Y M
0.93
Technologies11.44
5.Luminaire
Technologies 6.64
12.70
6.OCL
6.67
Informatics17.07
7.Telesys
4.34
Software 39.81
8.C S Software
8.54
Enterprise 22.98
9.V G L Softech
15.38
8.89
10.Integrated
12.37
Hitech 14.67
11.Zigma
1.63
Software 45.79
12.Visu Cybertech
24.74
5.21
13.V J I L
17.45
Consulting 21.34
14.Sark Systems
30.77
India 20.56
15.Fore C
22.12
Software 47.44
16.Pentagon
Global Solutions 32.24
36.99
Arithmetic mean 13.41
10. Since the NCP (Profit Margins) of above companies as per average arithmetic mean NCP)
was 13.41% against 11.07% earned by the taxpayer in the relevant assessment years, it was
claimed that taxpayer carried international transaction at Arm's Length if proviso to Section
92C(2) of I.T. Act permitting variation of +/5% is kept in mind. It was accordingly claimed
that international transaction carried by assessee was at arm's length.
11. The Transfer Pricing officer refused to accept above claim of the taxpayer. He raised
certain objections on the uncontrolled comparable selected by taxpayer in its computation of
Arm's Length Price. The TPO also objected to use of data for years other than the financial
year involved in question. In order to meet the objections of the T.P.O., the taxpayer on
8.11.04 gave fresh computation with reference to the following 16 companies and worked out
from relevant data the average net cost margin for F.A. 2001-02 at 3.07% against 6.99%
disclosed by the appellant. The detail is as under:-
S. Net cost plus

Company Name
No. Margin
1.MYM Technologies 4.81%
2.Kushagra Software -0.49%
3.VJIL Consulting 5.24%
4.Integrated Hitech -1.04%
5.Zigma Software 16.38%
6.Sark Systems 30.00%
7.Pentagon Global
2.43%
Solution
8.Shine Computech 0.47%
9.Fore C Software 5.76%
10.Visu Cybertech -2.76%
11.CS Software -25.12%
12.OCL Informatics 4.44%
13.Luminaire
0.00%
Technologies
14.Telesys Software 2.88%
Average Net Cost
3.07%
plus Margin
11. Two companies were considered and excluded as per the following note:-
"Note : VGL Softech has not been included in the set as it is a startup company. Further, Top
Media Entertainment has also been excluded as it does not have financials updated for March
2002."
12. The TPO in its order dated 18.3.05 has referred to above details. He has however
observed that the taxpayer did not carry any fresh search for comparables and has merely
reworked the figures of same 3 comparables as used in the audit report. Earlier, on 20th
January 2005, the TPO had asked the taxpayer to explain as to why companies having a)
substantially low turnover; b) companies engaged primarily in manufacturing activities and c)
companies with low employees cost should not be eliminated from the comparables taken
into account by the taxpayer. The TPO ultimately listed the following companies for
elimination from comparison in Para 7.5 of its order:-
Name of the company Reason for elimination

Kushagra Software Ltd. Manufacturing concern
Integrated Hitech Ltd. Low turnover
Fore C Software Ltd. Low employee cost
Luminaire technologies Low turnover
Ltd.
Telesys Software Ltd. Low employee cost

Pentagon Global Low employee cost. Engaged in
Solutions Ltd. Manufacturing activity
OCL Informatics Ltd. Low turnover
13. The TPO thereafter claimed to have carried independent search of comparable from the
PROWESS and CAPITALINE database and Nasscom directory and worked out the average
operational profit for comparison at 26.94% with the following remarks and details in para
7.6 of his order:-
"The search was conducted for the companies engaged in software development,
having turnover between Rs. 50 lakhs to Rs. 100 crores, having employee cost of
more than 10%, not having manufacturing and trading sales of more than 10%
of total sales and not having any related party transactions. After applying such
filters, the following set of companies was identified as comparables:
Name of company Operational Profit %

Blue Star Infotech Ltd. 27.18%
Ideaspace Solutions Ltd. 20.69%
Integrate Hitech Ltd. 3.16%
NIIT Gis Ltd. 28.80%
Quintegra Solutions Ltd. 37.89%
Sark Systems India Ltd. 27.91%
Teledata Informatics Ltd. 32.99%
Average OP/TC 26.94%"
14. In response of notice dated 27.1.2005 of the T.P.O. on above operating profit as a
benchmark, the taxpayer vide its reply dated 31.1.05 raised objections as under:- 1) that all
the companies selected with the exception of Sark Systems and Quintegra Solutions, have
either foreign parent or subsidiary company and are most likely to have related party
transactions. 2) That Quintegra Solutions is liable to be eliminated on account of difference in
project profile. The TPO on above objections observed that "he was not prepared to eliminate
companies having foreign parent or subsidiary company unless value of related party
transactions was furnished by taxpayer". The stand of taxpayer that the taxpayer was unable
to furnish value of related party transactions as relevant information relating to year 2001-02
was not available in public domain. The TPO accepted the fact that data of relevant year was
not available. However, the data of the subsequent years, according to the TPO could provide
an indication of the quantum of related party transactions that might have taken place in the
relevant year. Out of the companies considered for comparison, two companies namely Blue
Star Infotech and NUT Gis Limited had related party transactions in the year ended March
2004 though there was no evidence that these companies had related party transactions in
the year under reference (F.A. 2001-02), It has been observed by the T.P.O. in his order that
he felt "prudent to accord the benefit of doubt to the assessee that there could be a related
party transaction in respect of these two comparable companies for the year under
examination". Accordingly, above two companies were excluded from the proposed list of
comparable companies.
15. The TPO accordingly took other three companies for computation of average of OTC/TC
as those companies did not have any related party transaction in the year 2003-04.
16. Quintegra Solutions was included in the list of comparable with fallowing observations:-
"As far as the product profile of Qunitegra Solutions is concerned, the same was
re-examined consequent upon the objection raised by the assessee. It is found
that this company, too, is engaged in software development services and as such
is a fit comparable for analysis. Moreover, transactional Net Margin Method is
more tolerant to minor functional differences and is less affected by transactional
differences (para 3.27 of OECD report Transfer Pricing Guidelines for
Multinational Enterprises and Tax Administrations, July 1995). "
17. Thereafter, Arm's Length Price of the international transaction and adjustments were
worked out at Rs. 1,45,73,857 with the following remarks:-
"7.8 In view of the above discussions, the following list of comparable companies
are finally chosen for analysis.
Name of company OPTC (F.Y. 2001

Ideaspace Solutions Ltd. 20.69%
Integrated Hltech Ltd. 3.16%
Quintegra Solutions Ltd. 37.89%
Sark Systems India Ltd. 27.91%
Teledata Informatics Ltd. 32.99%
Average OP/TC 24.53%
Hence, the arithmetic mean of operating profit over the total cost margins of the comparable
companies for the financial year 2001-02 works out to 24.53%. The arm's length price of the
international transactions entered into by the assessee with its AE is worked as under:-
Total cost of provision of services by the

Rs.8,30,64,464
Assessee :
Margin @ 24.53% of the above : Rs. 2,03,75,713
Rs.
Arms length price to be charged from the AE
10,34,40,177
7.9 In the manner discussed above the arm's length price of the international
transactions entered into by the assessee with its AE is determined at Rs.
10,34,40,177 in place of Rs. 8,88,66,320/-
7.10 Accordingly, an adjustment of Rs. 1,45,73,857/- is to be made to the

income of the assessee, being the difference between the arm's length price and
the price charged by the assessee from its AE for rendering services to them.
7.11 As regards the marketing services, the assessee has relied on TNMM with
Net Cost Plus (NCP) margin as PLI. On examination of the documentation and the
functional analyses contained therein no adverse inference is drawn in respect of
this international transaction.
Sd/-(HIMANSHU SINHA)
JOINT COMMISSIONER OF INCOME TAX
(TRANSFER PRINCING OFFICER-I), NEW DELHI"
18. The taxpayer impugned above adjustment/addition on account of transfer pricing (INR
1,45,73,857) in appeal before the ld. C.I.T.(A) and vehemently challenged the report of the
Transfer Pricing Officer (T.P.O.) The taxpayer also claimed that it was entitled to claim
deduction u/s 10A of the Income Tax Act. The ld. CIT(A), after examining facts and
circumstances of the case, upheld the finding of the Assessing Officer (A.O.) that the
taxpayer was not entitled to deduction under provision of Section 10A of the Income Tax Act.
The reasons which weighed with him to uphold the denial was that the unit of the assessee
was an old unit in existence since the year 1998 and that in respect of this very unit,
assessee had claimed and was allowed deduction in the Asstt. Year 1999-00 which was the
first year of operation of the unit. The taxpayer, therefore, could not be permitted to change
its claim of deduction in respect of same unit from section 80HHE to Section 10A in
subsequent years. The claim of the taxpayer was against the intention of the legislature
which had clearly laid down that deduction u/s 10A with regard to export of profit was not
available to old units. The ld. CIT(A) further held that the taxpayer was also not entitled to
deduction u/s 80HHE in this year as mandatory requirement of the said section regarding
furnishing of the auditor's report in Form 10 CCAF along with the return of income was not
fulfilled. Accordingly, ld. CIT(A) upheld the rejection of claim of Rs.59,56,330 u/s 10A of the
l.T.Act.
19. Thereafter, the ld. CIT(A) considered grievance of the assessee on account of adjustment
of Rs. 1,45,73,857 representing the arm's length price. He noted that for the current financial
year 2001-02, the taxpayer had chosen Transactional Net Margin Method as most appropriate
method to determine arm's length price with operating profit margin over total cost (OP/TC)
as profit level indicator (PLI). The exercise carried by the taxpayer in identifying 16
comparable companies from PROWESS and working of weighted average operating margin of
taxpayer and other comparable companies was noted. The Ld. CIT(A) accepted that the
selection of the method i.e. TNMM as well as PLI i.e. OP/TC were found appropriate by the
TPO/A.O. The ld. CIT(A) was of the view that taxpayer was not justified in taking into account
data for the earlier two preceding years. In his view, only the data for the current year
should have been taken into account. He has given detailed reasons in different Paras. We
are not recording all reasons/details as during the course of hearing before us, ld.
Representative of the taxpayer agreed that Arm's length pricing has to be determined by
taking only the data of the current year. He fairly conceded that the Special Bench in the
case of Aztec International = (2007-TIOL-210-ITAT-BANG-SB) has also taken the same view and the
said view has to be followed by this regular Bench. The ld. CIT(A) also rejected the claim of
the Taxpayer that reference made by the Assessing Officer to the TPO u/s 92CA(1) was bad
in law and, therefore, order of TPO void for want of jurisdiction. This issue was also not
agitated in appeal before us as the same is covered against the taxpayer as per the Special
Bench decision referred to above.20. The ld. CIT(A) had also rejected the claim of the
Taxpayer that arm's length price determined by TPO was required to be reduced by 5% in
terms of proviso to Section 92C(2) of the Act. It was contended that variation of +/- 5% has
to be allowed in every case to the taxpayer while making adjustments in international
transaction on account of arm's length price in the light of mandate of proviso to Section 92C
(2) of the Act. The taxpayer had also placed reliance on Instruction No.3 dated 20.5.2003 of
CBDT, Ld. CIT(A) did not find any force in these contentions. We are also not considering the
finding of the ld. C.I.T.(A) on this aspect in details, as no arguments were addressed nor
issue agitated before us in appeal.21. The ld. CIT(A) further noted that TPO had carried
search of comparable companies from Prowess and Capitaline databases and Nasscom
Directory and identified seven companies with their performance for financial year 2001-02
as comparable companies. On further analysis, the T.P.O. had excluded two companies out of
above seven companies on account of objection of the taxpayer and finally a set of five
companies were chosen as comparable. The arithmetical mean of operating profit margin
over total cost (OP/TC) of these companies for the relevant financial year worked out at
24.53%. On the basis of above comparable cases, cost of provisions of software development
services were determined at Rs. 10,34,40,177 against Rs.8,88,66,320 disclosed by the
assessee. This way, addition of Rs. 1,45,73,857 according to the ld. CIT(A) was rightly made.
As in the proceedings before the Tribunal, the ld. Representative of the taxpayer had
vehemently challenged selection of comparables by the TPO, it would only be appropriate to

take note of the finding recorded by ld. CIT(A) on the selection of cornparable by the TPO.
After noting as to what is required to be done while determining ALP by tax authorities u/s
92C/CA r/w Income Tax Rule 10B, the ld, CIT(A) upheld the assessment. His concluding
observations are as under:-
58. The contentions of the appellant challenging the reliability and correctness of
the comparable uncontrolled transactions are, thus, found to be baseless and
without any merit and the same are, accordingly, rejected. On a careful
consideration of the fads and circumstances of the case and the relevant position
of the law, I am of the considered view that TPO has correctly selected the set of
five independent companies having comparable uncontrolled transactions for
determination of arm's length price of the international transactions and his
action in this regard is, accordingly, confirmed.59. The arm 's length price of the
international transactions of export of software development services has been
determined by the TPO by taking into account the arithmetic mean of operating
profit margins over total cost (OP/TC) of the above five comparables independent
companies having comparable uncontrolled transactions. The arithmetic mean of
the OP/TC of these comparable companies was worked out to 24.53%. By
applying this arithmetic mean margin of 24.53% to the total cost of provision of
software development services amounting to Rs.8,30,64,464/-, the arm's length
price in respect of international transactions of export of software development
services to the AE was determined by the TPO at Rs. 10,34,40,177/-. In fact,
initially there would be five arm 's length prices if OP/TC of each of above five
comparable independent companies is separately applied to the total cost.
Thereafter the arithmetical mean of such five arm 's length prices shall be taken
as the arm's length price under the proviso to section 92C(2) of the Act. The
arm's length price determined by the TPO at Rs. 10,34,40,177/- by taking the
arithmetic mean of OP/TC of all five comparable companies actually presents the
arithmetical mean of the arm 's length prices under the proviso to section 92C(2)
of the Act.60. As against the arithmetic mean arm's length price of Rs.
10,34,40,177/- determined by the TPO, the appellant had charged the transfer
price from its AE only at Rs. 8,88,66,320, The price so charged by the appellant
was 14.09% less than the arithmetical mean of arm 's length prices determined
by the TPO. Thus, the difference between the price charged by the appellant and
the arithmetical mean arm 's length price determined by the TPO exceeded the
permissible variation of +/- 5%. Therefore, as discussed in detail hereinbefore,
the benefit of reduction of the arithmetical mean arm's length price up to 5% was
not allowable to the appellant in such a case. Consequently, the addition on
account of transfer pricing adjustment would be made for the difference between
the arithmetical mean arm s length price of Rs.10,34,40,177/-determined by the
TPO and the transfer price of Rs.8,88,66,320 charged by the appellant. The
difference between these two prices works out to Rs. 1,45, 73,857/- and the
same was, accordingly, added by the Assessing Officer to the total income of the
appellant.
61. In view of the foregoing and on a careful consideration of the facts and
circumstances of the case and the relevant position of the law, I am of the
considered view that the Assessing Officer was justified in making an addition of
Rs. 1,45, 73,857/- to the total income of the appellant on account of difference
between the arm's length price determined by the TPO and the transfer price
charged by the appellant from its AE in respect of international transactions of
export of software development services and the addition so made by him is,
accordingly, confirmed. "
22. The taxpayer being aggrieved has impugned the order of the ld. CIT(A) in appeal before
the Income Tax Appellate Tribunal (in short Appellate Tribunal). We have heard both the
parties and taken into account material on record to which our attention was drawn. In the
case of Aztech Software & Technology Services Ltd. Vs ACIT 249 ITR (AT) 32 = (Special
Bench in the case of Aztec International = (2007-TIOL-210-ITAT-BANG-SB), the Special Bench of
five members considered the statutory provisions of income Tax Act and Rules relating to
Transfer Pricing and held as under:-
"Computation of the arm's length price is essentially a factual exercise. Each case
depends on its own peculiar facts and circumstances. In certain cases where an
identical or almost similar uncontrolled transaction is available for comparison
determination of the arm 's length price is an easy task. However, it is not so in
most transactions and rarely is one able to locate an identical transaction. In such
cases the arm 's length price is determined by taking the results of a comparable
transaction in comparable circumstances and making suitable adjustments for the
differences.The fundamental requirement, in any of the methods selected, is the
selection of "comparables, for benchmarking international transactions. This
selection of a comparable should be based on functional, asset, and risk analysis
of both the parties and transactions. Whatever methodology is chosen for the
purpose of determination of the arm's length price under section 92C, these
criteria, as specified in the Act and the Rules have to form a basis of judging the
comparability.
Thus, there should be a proper analysis of such transactions with respect to the
functions performed, the assets employed and the risk assumed by the respective
parties with reference to the transaction in question. This can be termed as
functional, asset, risk analysis, i.e., FAR analysis. All the three ingredients of FAR
have a direct bearing on the pricing of products/services. The provision also
provides scope for carrying out adjustments in case where there are some
differences or variations to make two transactions commercially comparable, for
the purpose of benchmarking. The adjustments are suggested to achieve the
object of testing and trying to see if both the parties or/and the transactions are
similar or nearly similar. "
23. In the case of DIT (International taxation) Vs Morgan Stanley 292 ITR 416 = (2007-TIOL-
125-SC-IT), the Hon'ble Supreme Court after considering relevant Indian regulations on transfer
pricing made some pertinent observations which are noted as under:-
"The object behind enactment of transfer pricing regulations is to prevent shifting

of profits outside India.xxxxxxxxThe impugned ruling is correct in principle in so
far as an associated enterprise, that also constitutes a P.E. has been remunerated
on an arm's length basis taking to account all the risk/taking functions of the
enterprise.xxxxxxxx
where the transaction between the two are held to be at arm's length basis
taking into account all the risk-taking functions of the multinational enterprise. In
such a case nothing further would be left to attribute to the P.E. The situation
would be different if the transfer pricing analysis does not adequately reflect the
functions performed and the risks assumed by the enterprise. In such a case,
there would be need to attribute profits to the P.E. for those functions/risks that
have not been considered. "
24. It is true that "transfer pricing" is not an exact science, evaluation of transactions
through which the process of determination is carried in an art where mathematical certainty
is indeed not possible and some approximation cannot be ruled out, yet it has to be shown
that analysis carried was "judicial" and was done after taking into account all the relevant
facts and circumstances of the case. Minimum requirement is to prima facie show that
controlled international transaction was properly examined, comparable and arms' length
price fixed objectively, honestly and in a bona fide manner as required by the statutory
regulations. The requirement of the statutory regulation has been thoroughly discussed by
the Appellate Tribunal in the case of Aztech Software (supra), but in order to dispose of this
appeal, these are reiterated here:-25. The comparability of an international transaction i.e.
uncontrolled transaction and a controlled transaction is to be judged under Rule 10B(2) 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.
Further caution required to be adopted while looking to the differences between controlled
and uncontrolled transaction is provided in sub-rule (3) of Rule 10B which is as under:-
"(3) An uncontrolled transaction shall be comparable to an international

transaction if-(i) none of the differences, if any, between the transactions being
compared, or between the enterprises entering into such transactions are likely
to materially affect the price or cost charged or paid in, or the profit arising from,
such transactions in the open market; or (ii) reasonably accurate adjustments
can be made to eliminate the material effects of such differences.'Further "Rule
10B(1)(e) of Income Tax Act providing for determination of Arm's Length Price
u/s 92C required that following steps are to be taken while applying TNMM after
selection and evaluation of controlled transactions. It is as under:-"(e)
transactional net margin method, by which. -(i) (i) the net profit margin realized
by the enterprise from an international transactions 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 realized 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 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 realized by the enterprise and referred to in sub-clause (i) is established
to be the 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."
As noted in the case of Aztech Software (supra) "rarely one is able to locate an
identical uncontrolled transaction". The Arms' Length Price is determined by
taking result of a comparable transaction in comparable circumstances and by

making suitable adjustments for the differences.
26. The first step in the determination of Arms Length Price is to analyse the specific
characteristics of the controlled transaction whether it relates to transfer of goods, services or
intangible. Without proper study of specific characteristics of controlled transaction, no
meaningful comparison or location of comparable is possible. For example, a mere
consideration that controlled transaction relates to "software supply" is not sufficient as there
are hundreds of softwares with different characteristics which materially affect their open
market value. The characteristics that are required to be considered include in case of
transfer of tangible property, the physical feature of the property, its quality, reliability and
availability (supply). In case of provisions of services, the nature and extent of services and
where tangible property is involved for comparison, the form of transaction. To put it in other
words, all the characteristics of the controlled transaction which are likely to affect its open
market value must be taken into account. The study should include analysis of functions, risk
and assets of the controlled transaction for correct location of similar or nearly similar
characteristics in uncontrolled transactions. Specific characteristics are necessary to carry
search of similar comparable with similar characteristics.27. After the selection of the
comparables. best method of determining Arms' Length Price is selected. Thereafter,
functional analysis is carried to identify functions, risk and assets of uncontrolled transactions
and comparison is carried with characteristics of the controlled transaction. This is necessary
to find whether comparable selected are really comparable and reliable. Comparison based
on functional analysis include economically significant activities and responsibilities
undertaken or to be undertaken by the independent and associated enterprises. The
structure and organization of the group and more particularly the judicial relationship
between different entities of same group are to be seen. The function that need to be
identified while carrying comparison as per OECD guidelines include design, manufacturing,
assembling, research and development, servicing, purchasing, distribution, marketing,
advertising, transportation, financial and management activities. It is also necessary to
examine as to what is the principal function of the entities. The analysis of comparison should
consider total assets employed and assets used to earn profit. The risk assumed by
respective parties is a very important consideration. It is a simple principle of economics that
the greater the risk, the greater the expected return (compensation), If there are material
and significant differences in the risk involved, then the comparable identified are not correct
as appropriated adjustments for differences in such cases are not possible. Therefore, while
performing searches for potential comparable companies, not only turnover and operating
profit but functions performed and risk profile are also to be considered. However, it can
always be shown on the given facts of the case that comparable found are similar or almost
similar to the controlled transaction and no adjustments are needed. It is useful to see the
level of intangible assets in comparable to an appropriate base. Depending on facts of the
case, final set of comparables may need to eliminate differences by making adjustments for
the following:
a) a) working capital b) b) adjustment for risk and growth
c) c) adjustment of R&D expenses
27.1 The risk not only due to human resources, infrastructure and quality which are normally
taken into account yet more significant risks like market risk, contract risk, credit and
collection risk and risk of infringement of intellectual property are being ignored here. In
most of the comparable analysis carried in India, the latter type of risk are not being taken
into consideration although these can lead to major difference in Market Value of
transactions.27.2 The European tax authorities are reluctant to accept "adjustments" because
adjustments necessarily involve consideration of question whether they are appropriate or
not and therefore it is always better to find comparable requiring the least or no adjustment.
The position in India as per Indian regulations on the subject has been noted earlier. If there
are differences which can be adjusted, then adjustments are required to be made. If the
difference between the companies are so material that adjustment is not possible, then
comparables are required to be rejected.27.3 Further in the analysis numerous ratio are
applied, depending on the specific of the comparables. The search may include the
following:-
Inventory/sales; operating assets to total assets, fixed assets to total sales, fixed
assets to number of employees, operating expenses to sale, cost of sales.
28. In the present case, there is agreement between the parties that Transaction Net Margin
Method for determination of Arm's Length Price was the most appropriate method. It was
attempted to be applied by both the parties.29. The ld. CIT(A) in para 15 of the impugned
order has specifically agreed and has recorded as under:-
"The selection of method i.e. R.N.M.M. the PLI i.e. the OP/ TC were found to be
appropriate by the Assessing Officer. "
30. On facts, we are not inclined to go into the issues not disputed before us. It is part of the
agreement between the parties that all companies selected as "comparable" had operated
from India in supply of softwares etc. We therefore proceed to decide the dispute on above
accepted premises. The dispute is confined to selection of reliable and authentic
comparable.31. It is the case of the taxpayer that if proper selection is made by applying
proper filter (FAR), the PLI of comparables would be 3.61% as against 6.99% of the taxpayer
and, therefore, Arms Length principles are fully satisfied and no adjustments need in the
international transaction carried by the taxpayer with its AE. The T.P.O., on the other hand,
has worked arithmetic means of OP/TC at 24.53% as noted earlier and determined Arms'
Length Price of international transaction at INR 10,34,40,177 leading to addition of INR
1,45.73.857.32. It is undisputed and fully borne from record that tested party was
developing specific software for its parent company, the software developed by the taxpayer
was used by parent in-house for integrating the same with other software components
developed by itself. The whole software, in turn, supported the hardware manufactured by
the parent and sold as a package in the open market. The role of the tested party has been
that it is a contract software development support service provider. It is a captive
company.33. Most of the business risk such as contract risk, market risk, credit risk,
warranty risk, price risk etc. were essentially borne by parent AE. Normal foreign exchange
risk was borne by the taxpayer.34. The Intellectual Property Right (IPR) was owned by
parent AE in all intangibles that were provided to the taxpayer for carrying out software
development services. The taxpayer emphatically and rightly claimed which is not disputed
that it does not own any valuable intangibles, the parent AE had provided necessary
intangible such as software and other proprietary tools and process to carry out the software
development. All intangibles including discoveries, improvement, inventions and trade secrets
conceived or reduced to practice were the sole and exclusive property of the Parent AE. The
taxpayer only maintained and deployed necessary human resources and infrastructure for
development of software. The above stated specific characteristics were required to be
considered under the Indian Regulation Rule 10B noted above and even under OECD
guidelines. However, above characteristics of controlled transactions were evidently not kept
in mind by the T.P.O. to find comparable and. therefore, order of T.P.O./basis of adjustments
is not sustainable on above grounds. The TPO committed several minor and major errors
while computing the so-called Arms' Length Price.35. In the first place, while screening and
filtering for comparables, he took into account companies which were dealing with their
related companies either as subsidiaries or as parent companies. Thus, controlled
transactions were taken into account which is against the very basics of the transfer pricing
guidelines. When it was pointed out by the assessee in objection dated 31.1.05 (refer para
7.51 of the TPO's order), the TPO put on the assessee to "bring on record any related party
transactions of companies chosen as comparables". The assessee then pointed out that the
above data in Jan., Feb. 2005 for financial year 2001-02 was not available in public domain
base PROWESS and CAPITALINE and, therefore, could not be produced. This position is
admitted by T.P.O. in his order. The approach of the ld. T.P.O. cannot be approved, after all
T.P.O. was carrying judicial or quasi-judicial proceeding. After accepting that the data for
financial year 2001-02 was not available at that relevant time in 2005, the TPO considered
data of two years later i.e. for financial year 2003-04 and found that two companies namely
Blue Star Infotech Ltd. and NIIT Gis Ltd. had related transaction and, therefore, these two
companies were excluded from the list of comparables selected by the TPO. As regards other
selected companies, these were included in the list as related party transactions were not
found in the financial year 2003-04. The T.P.O. presumed that related party transactions
were not carried in F.Y.2001-02 without considering relevant data for F.Y. 2001-02 as is
clearly admitted hereinafter. The T.P.O. has observed:-
"The other three companies, proposed to be chosen as comparables did not have
any related party transaction in the year 2003-04. Hence, under the same
premise, it has been presumed that these companies did not have any sizeable
value of related party transaction in the year under examination and accordingly
these comparables were retained for analysis and benchmarking."
35.1 From the above, three facts are clearly established: 1) That in selecting comparables,
the TPO chose transactions which included transactions with related parties; 2) The
observations that he had carried search and selected parties "not having any related party
transaction" made in para 7.6 of order are hollow and untenable; 3) T.P.O. has used data for
financial year 2003-04 to verify transactions of financial year 2001-02 after prohibiting the
taxpayer to use data for any year other than F.A. 2001-02. The conclusion and the inference
that as in data for financial year 2003-04. there was no related transaction, a presumption
can be drawn that even in the financial year 2001-02 i.e. two years earlier, there were no
inter-party transactions. Such inferences and presumptions are not authorized and cannot be
accepted. Assessment under the Act is a judicial act and must be based on cogent material,
not on unsound presumption. There is no nexus between the material available on record and
the conclusion drawn. Further one wonders and finds no answer to the pertinent question; if
data for F.Y.2001-02 was not available in the year 2005. as is the admitted position, then
how and wherefrom transactions with features as mentioned in para 7.6 of order were found?
On facts, we hold that TPO carried search which had serious defects materially affecting the
determination of Arms' Length Price and his order can not be accepted as legally correct.
35.2. Further there is contradiction in the approach of TPO; whereas he rightly insisted in the
light of Rule 10B(4) that only data for the financial year was relevant but for his own use, he
has taken into account data for financial year 2003-04 i.e. relating to two years later.35.3
One more problem with the order of T.P.O. is that he did not take into account specific
characteristics of the controlled transaction while searching for comparable and failed to
apply FAR test to controlled or potentially comparable uncontrolled
companies/transactions.36. In the present case, specific characteristics of services provided,
functions performed, assets employed and risk assumed are reiterated as under:-
"The taxpayer as noted above is providing software development support services

to its parent AE as per the instructions of its parent company. It does not
create/develop/sell software products and packages. The software developed by
the appellant is used by the parent in-house for integrating the same with other
software components developed by the parent AE itself. The appellant business is
therefore limited to providing software development support services. Further,
taxpayer assumes low business risks and employs only routine tangible assets
i.e. it does not develop or own any valuable or non-routine intangibles."
36.1 There is no dispute about above characteristics or FAR of the taxpayer. However, above
characteristics do not appear to have been taken into account by the ld. TPO while
undertaking screening and elimination of companies. Ultimately, when five companies were
selected by the TPO for comparison, the material on record does not show that TPO cared to
know the size of those companies. There is no mention of the characteristics of companies
adopted and whether those companies had any intangible properties or what was the ratio of
fixed and operating assets. Whether those companies were also low risk companies like that
of the taxpayer. Even on prima facie consideration of the companies selected, it is found that
PIL variation between them is very wide throwing doubt on correctness of analysis.36.2 In
TPO's views, the Transaction Net Margin Method being more tolerant to minor functional
differences, there was no need to carry functional and other analysis to find difference in
transactions. For this purpose, he relied upon para 7.27of OECD report of July 1995. In our
opinion, para 3.27 has been taken by TPO out of context. In the Guidelines the strength and
weaknesses of the Transaction Net Margin Method has been compared with other methods
and one strong point stated has been overemphasized by the T.P.O. This is what has been
stated in para 3.27:-
"3.27 One strength of the transactional net margin method is that net margins
(e.g. return on assets, operating income to sales, and possibly other measures of
net profit) are less affected by transactional differences than is the case with
price, as used in the CUP Method. The net margins also may be more tolerant to
some functional differences between the controlled and uncontrolled transactions
than gross profit margins. Differences in the functions performed between
enterprises are often reflected in variations in operating expenses. Consequently,
enterprises may have a wide range of gross profit margins but sill earn broadly
similar levels of net profits."
36.3 Extracts from other Paras 3.29. 3.34. 3.35. 3.37 and 3.39 of the same guidelines would
clearly show that the inference drawn is one-sided. These paras are as under:-
"3.29 There are also a number of weaknesses to the transactional net margin
method. Perhaps the greatest weakness is that the net margin of a taxpayer can
be influenced by some factors that either do not have an effect, or have a less
substantial or direct effect, on price or gross margins. These aspects make
accurate and reliable determinations of arm's length net margins difficult. Thus, it
is important to provide some detailed guidance on establishing comparability for
the transactional net margin method, as set forth in sub-section (c)(1)
below."3.34 Prices are likely to be affected by differences in products, and gross
margins are likely to be affected by differences in functions, but operating profits
are less adversely affected by such differences. As with the resale price and cost
plus methods that the transactional net margin method resembles, this, however,
does not mean that a mere similarity of functions between two enterprises will
necessarily lead to reliable comparisons. Assuming similar functions can be
isolated from among the wide range of functions that enterprises may exercise, in
order to apply the method, the profit margins related to such functions may still
not be automatically comparable where, for instance, the enterprises concerned
carry on those functions in different economic sectors or markets with different
levels of profitability. When the comparable uncontrolled transactions being used
are those of an independent enterprise, a high degree of similarity is required in
a number of aspects of the associated enterprise and the independent enterprise
involved in the transactions in order for the controlled transactions to be
comparable; there are various factors other than products and functions that can
significantly influence net margins."3.35 The use of net margins can potentially
introduce a greater element of volatility into the determination of transfer prices
for two reasons. First, net margins can be influenced by some factors that do not
have an effect (or have a less substantial or direct effect) on gross margins and
prices, because of the potential for variation of operating expenses across

enterprises. Second, net margins can be influenced by some of the same factors,
such as competitive position, that can influence price and gross margins, but the
effect of these factors may not be as readily eliminated. In the traditional
transaction methods, the effect of these factors may be eliminated as a natural
consequence of insisting upon greater product and function similarity."3.37
Assume, for example, that a taxpayer sells top quality video cassette records to
an associated enterprise, and the only profit information available on comparable
business activities is on generic medium quality VCR sales. Assume that the top
quality VCR market is growing in its sales, has a high entry barrier, has a small
number of competitors, and is with wide possibilities for product differentiation.
All of the differences are likely to have material effect on the profitability of the
examined activities and compared activities, and in such a case would require
adjustment. As with other methods, the reliability of the necessary adjustments
will affect the reliability of the analysis. It should be noted that even if two
enterprises are in exactly the same industry, the profitability may differ
depending on their market shares, competitive positions, etc."
3.39 The transactional net margin method may afford a practical solution to
otherwise insoluble transfer pricing problems if it is used sensibly and with
appropriate adjustments to account for differences of the type referred to above.
The transactional net margin method should not be used unless the net margins
are determined from uncontrolled transactions of the same taxpayer in
comparable circumstances or, where the comparable uncontrolled transactions
are those of an independent enterprise, the differences between the associated
enterprises and the independent enterprises that have a material effect on the
net margin being used are adequately taken into account. Many countries are
concerned that the safeguards established for the traditional transaction methods
may be overlooked in applying the transactional net margin method. Thus where
differences in the characteristics of the enterprises being compared have a
material effect on the net margins being used, it would not be appropriate to
apply the transactional net margin method without making adjustments for such
differences. The extent and reliability of those adjustments will affect the relative
reliability of the analysis under the transactional net margin method."
37. It is clear that even when TNMM method is applied to determine arm's length price as per
OECD guidelines, functional profile, assets, assumed risks of controlled and uncontrolled
transaction are to be seen while screening. Besides, it is not possible to ignore specific Indian
regulations on the subject. We have already noted the relevant rule (2) and (3) 10B of I.T.
Rules, which specifically require to consider for comparison "the functions performed assets
employed ... and risks assumed by respective parties" In Rule 10(B)(1)(e) of I.T. Rules
providing for determination through TNMM, it is clearly-provided in clause (iii) "the net profit
margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is
adjusted to take into account the difference if any". These regulations have force of law and
notwithstanding OECD guidelines, the T.P.O. can not refuse to consider specific
characteristics of transaction, functions performed and assets employed as has been done in
this case. Total disregard of regulations non-application of filters as above has resulted in
faulty selection of comparison. All sizes of companies have been selected, only commonality
being their dealings in softwares. We are unable to hold and approve the approach of T.P.O.
as correct. The wide difference in the ratio of operating margins between 3.16% to 37.89%
in final selection of comparable by the T.P.O.. is a clear pointer to the fact that the selection
made was faulty. It was imperative for the TPO to carry on further analysis and evaluation of
companies selected and to see whether this variation is on account of FAR etc. The OECD
guideline on this point is as under : -
"1.47 Where the application of one or more methods produces a range of figures,
a substantial deviation among points in that range may indicate that the data
used in establishing some of the points may not be as reliable as the data used to
establish the other points in the range or that the deviation may result from
features of the comparable data that require adjustments. In such cases, further
analysis of those points may be necessary to evaluate their suitability for
inclusion in any arm's length range."
38. The TPO neither followed mandatory provision of Rule 10B quoted above nor guidelines of
OECD and his computation of ALP is patently erroneous.38.1 In the case of EIDU Pont de
Nemours & Co. V/s US (1979) 608 F2d 608, the US Court upheld the adjustment made on
account of arm's length determination although gross profit in the controlled transaction was
comparable to the gross profit of uncontrolled transactions but the taxpayer was found to
have claimed excessive expenses to reduce comparative net profit margin and. therefore, the
adjustments were made and upheld. The case is an illustration how close minute examination
of controlled and uncontrolled entities is essential under the Transfer Pricing Policy.39. As
regards the companies selected by the TPO. the Tax payer had further raised the following
objections:-
It has been pointed out that turnover of the taxpayer in the software
development segment in the relevant period was Rs,8.8 crores. Therefore,
assessee while screening data, selected companies between turnover of INR 47
lakh to INR 25.71 lakh. Accordingly, it was submitted that the numericals showed
that comparable companies selected by taxpayer formed proper mix of
companies in terms of turnover and was an ideal set for comparison in terms of
turnover and, therefore, the TPO's objection was without any basis. It is not clear
as to what according to the TPO was "low" turnover companies as he himself
applied range of INR 50 lakh to INR 100 crore and, therefore, slightly less
turnover than INR 50 lakh could not be construed as ''low". Therefore, according
to the taxpayer there was lack of application of mind and arbitrariness in the
approach of the TPO. It has been further pointed that turnover of the two
companies "Integrated Hitech Ltd." and "Luminaire Technologies Ltd." in the
relevant year was not less than INR 50 lakh. The taxpayer has given correct
turnover figures in the paper book in Table 5 of the synopsis (the paper book). It
has further been pointed out that Integrated Hitech Ltd. has been accepted by
TPO in his own selection. It is accordingly argued that comparables selected by
the taxpayer fully satisfied INR 50 lakh threshold limit set by the TPO except one
company OCL Informatics Ltd. Yet the comparable selected by the taxpayer were
held wrong and not accepted.
39.1 The TPO's objection that taxpayer in the comparative selection of company did not
consider the fact that some selected companies were in their initial years. This objection,
according to the taxpayer is also without any material. It is submitted that the taxpayer
company was incorporated on February 27, 1998 and the year under consideration is the
fourth year of its operations. It has given list of incorporation of all other companies to point
out that all the companies selected were incorporated before the taxpayer except for Zigma
Software Ltd. and VGL Softech. It is further submitted that Sark System incorporated in
1998, and which was in operation for less than four years was selected by TPO himself as a
comparable company. Therefore, there was no justification for discrediting the comparable
selected by the taxpayer.39.2 The other objection of the TPO that the taxpayer did not
exclude companies having high ratio of trading activities and manufacturing activities was
also without any basis or justification. The taxpayer while screening for comparable
eliminated companies having manufacturing sales greater than 25% of total sales and trading
sales greater than 25% to total sales. The TPO. on the other hand, applied a 10% threshold
in this regard. The taxpayer has taken pains to show through Table 7 in the paper book that
most of the companies satisfied the criteria of less than 10% sale with the exception of three
companies i.e. Kushagra Software Ltd.. Luminaire Technologies Ltd. and M Y M Technologies
Ltd. It is therefore clear that the TPO failed to apply criteria and standards set by him and
arbitrarily rejected the case of the taxpayer. 39.3 The TPO had also wrongly objected that
taxpayer did not exclude companies having low employee cost. It has been stated by the
taxpayer that insisting on low employee cost is not a very credible rational selection criterion
and TPO, during the course of assessment proceedings did not point, with reference to any
material, as to what is the economic rationale for using this criteria. It is relevant to mention
that employee cost is low/similar throughout India and this is not a factor which would make
material difference. Where such cost is extraordinary abnormal, the product dealt with is also
extraordinary and, therefore, entire profile of the entity is required to be examined for
comparison. Without prejudice to the above and on facts, the taxpayer as per Table 8 of the
paper book page 2 has shown that companies selected by the assessee had several
companies with cost below 10 or 10% and therefore fully satisfied the threshold limit set by
the TPO himself except for five companies, yet the TPO. without any reasonable justification,
did not accept the claim of the appellant.39.4 It has been accordingly contended that TPO
committed many errors and was wrong in discrediting list of comparables found and
furnished by the taxpayer. The TPO could have carried fresh search only if the comparables
drawn by the taxpayer was insufficient or had other deficiency. We are of the view that
objection raised on behalf of the taxpayer are well-founded and were wrongly disregarded by
the T.P.O.40. In the end, the assessee appellant has analyzed that even after adopting the
criteria/benchmarks set by the TPO for selection of comparables, there are seven companies
which satisfy all the criteria and this way average OP/TC were counted at 6.99%.Table 9 -
Appellant's Comparables after applying all of the TPO's Rejection Criteria
OP/TC (FY
S.No.Company
2001-02 Data)
1.C S Software Enterprise Ltd -25.12%
2.Integrated Hitech Ltd 3.16%
3.Reynolds Software Solutions Ltd. (formerly
0.47%
Known As "Shine Computech Ltd.')
4.Sark Systems India Ltd 27.91%
5.V J I L Consulting Ltd 5.24%
6.Visu International Ltd -2.76%
7.Zigma Software Ltd 16.38%
8.Arithmetic Mean 3.61%
40.1 It is further seen that apart from specifically accepting comparable case of integrated
Hitech Ltd., the TPO did not make any adverse comment on 8 companies taken as
comparable, by the taxpayer. None of the objections raised by the TPO are shown to be
applicable to those companies. It is therefore not clear why those companies were not taken
as comparable companies. At page 22 of the paper book, the taxpayer has pointed out that
arithmetic mean of OP / TC of those companies works out to 4.47% as per the following
detail:-
S.No.Company OP/TC
1.MYM Technologies 4.81%
3.VJIL Consulting 5.24%
5.Zigma Software 16.38%

6.Sark Systems 30.00%
8.Shine Computech 0.47%
10.Visu Cybertech -2.76%
11.CS Software -25.12%
15.VGL Softech 6.74%
16.Top Media Entertainment No data available
Mean 4.47%
41. The taxpayer has also vehemently challenged general observation of the T.P.O, that
selected company had a different product profile. The taxpayer has vehemently challenged
above interpretation of different profile.42. Smt. Himalini Kashyap. ld. CIT. DR supported the
impugned order of the Transfer Pricing Officer and that of the ld. ClT(A). She argued that
comparable as far as possible with reference to data available in public domain were selected
by the T.P.O. to fix Arm's length price. Therefore, on the reasons given by the T.P.O., the
adjustment made in the assessment order of the taxpayer should be upheld. Alternatively, it
was submitted that she does not have any material with her to challenge comparable
operating margin of comparable companies relied upon by the assessee before the Appellate
Tribunal or even those stated by the T.P.O. in his order. Therefore, to verify the claim, the
matter should be remitted back to the T.P.O. and Arm's length Price should be re-determined
in the light of objections of the taxpayer. She also claimed that assessee relied upon fresh
evidence.43. All these submissions were opposed by ld. representatives of the taxpayer as
factually incorrect.44. On careful consideration of the rival submissions, we are of the view
that contention advanced by ld. DR cannot be accepted. No fresh material has been relied
upon by the taxpayer before the Appellate Tribunal. How and wherefrom revenue was to
collect material in support of their case was the problem of the revenue and on that we do
not wish to comment. We have also considered in detail order of the T.P.O., the very basis of
addition/adjustment made in this case. For the reasons recorded above, we do not approve
of the order and hold that Arm's Length Price determined by T.P.O. is not sustainable.45. As
discussed in detail above, the Assessing Officer did not apply Indian regulation or guidelines
issued by OECD on transfer pricing. The taxpayer, on the other hand, carried out proper
screening of approximately 8000 companies carrying business of software in India and
exporting services and goods abroad. It took into account characteristics of its company in
question for the relevant assessment year and thereafter made selection of company after
applying functional test with reference to assets employed and risk taken by those
companies.46. Though identical transaction could not be located even by the assessee, an
attempt was made to find comparable transactions as close as possible to the controlled
transaction. Besides the assessee has rightly relied upon the transaction in the case of
Integrated Hitech Ltd. with operating profit ratio of 3.16%. This transaction has been
accepted as comparable by the TPO and, therefore, there is nothing further for the taxpayer
to establish that controlled transaction with AE was an arm's length transaction. Besides the
above, the T.P.O. also did not make any adverse comment on the following independent
transactions given in the list of comparable by the taxpayer:-
Company Name OP/TC

MYM Technologies 4.81%
VJIL Consulting 5.24%
Shine Computech 0.47%
VGL Softech 6.74%
46.1 We are not taking into account high profit or high loss making companies as
comparables. All the above, independent comparables have shown profit margin of less than
the assessee and, therefore, in the light of above evidence, there is no reason to hold that
taxpayer's international transaction with AE is at arm's length. It has no tangible assets
worked in no risk environment are very strong points of the taxpayer, not refuted on
record.46.2 While holding so, we have not adopted mean profit of several comparable found
by respective parties because in spite of our repeated requests, the parties before us, were
unable to show us any rule or decision under which average or mean margin (OP/TC) of
different companies is to be taken. Tax administration and parties can work different Arm's
length price i.e. a range by the application of different methods. In such a situation, mean of
Arm's Length Price as provided in proviso to Section 92C(2) of the Act can be taken. But
above Arm's length range is not the same thing as average operating profits of different
entities with different FAR worked through the same method as done in this case by adopting
TNMM. The assessee has satisfied not one but several points of arms' length range worked
out on record. In our considered view, it is not necessary for the taxpayer to satisfy all points
in the range. Even if one point is satisfied, the assessee can be taken to have established its
case and in that situation, the onus is shifted to the department to show why taxpayer's case
be not accepted. Arm's length price does not mean maximum price or maximum profit in the
range. A willing buyer in an open market shall pay minimum and not maximum price for
goods or services. Of course, quality and brand name are important but considered not so by
T.P.O. as TNMM method was applied by him. Project profile and other factors were, therefore,
not erroneously considered. As noted earlier, the case of Integrated Hitech has been
specifically accepted as comparable by both the parties. On other four cases noted above, the
T.P.O. or other revenue authorities have not made any adverse comment at any stage of
proceeding, it was open to them in proceedings before the ld. CIT(A) or the Appellate
Tribunal to show that PIL figure of Integrated Hitech or other four companies were wrong or
on account of their FAR analysis, these entities could not be taken as "reliable" comparables
for computation of the Arm's Length Price. But no material was brought on record, no
arguments advanced to reject the above transaction. Therefore, having regard to facts of the
case and material on record, we accept them as comparable and accept the price disclosed
by the taxpayer as Arm's Length Price. Consequently, the addition of Rs. 1,45,73,857 is
directed to be deleted. The view taken by us finds support from para 1.4 of OECD guideline
which we quote below:-
"1.48 If the relevant conditions of the controlled transactions (e.g. price or

margin) are within the arm's length range, no adjustment should be made. If the
relevant conditions of the controlled transaction (e.g. price or margin) fall outside
the arm's length range asserted by the tax administration, the taxpayer should
have the opportunity to present arguments that the conditions of the transaction
satisfy the arm's length principle, and that the arm's length range includes their
results. If the taxpayer is unable to establish this fact, the tax administration
must determine how to adjust the conditions of the controlled transaction taking
into account the arm's length range. It could be argued that any point in the
range nevertheless satisfies the arm's length principle."
47. Before close, we would like to draw attention to the following observation of the Supreme
Court, in the case of Parashuram Pottery Works Co. Ltd. Vs ITO (1977) 106 ITR 1 = (2002-
TIOL-573-SC-IT) wherein it was observed as under:-
"It has been said that the taxes are the price that we pay for civilization. If so, it
is essential that those who are entrusted with the task of calculating and realizing
that price should familiarize themselves with the relevant provisions and become
well-versed with the law on the subject. Any remissness on their part can only be
at the cost of the national exchequer and must necessarily result in loss of
revenue. At the same time, we have to bear in mind that the policy of law is that
there must be a point of finality in all legal proceedings, that stale issues should
not be reactivated beyond a particular stage and that lapse of time must induce
repose in and set at rest judicial and quasi-judicial controversies as it must in
other spheres of human activity."
48. That in the other ground, the taxpayer has raised objection on denial of deduction u/s
10A of the I.T. Act. The question of allowability of claim to the appellant u/s 10A has already
been considered and decided in the assessment year 2001 in the case of this very assessee,
The Bench, after following the decision of the Tribunal in the case of Legato Systems India
(P) Ltd. Vs ITO 93 TTJ 828. restored the matter to the file of the Assessing Officer to make
further inquiry and allow deduction to the assessee.48.1 The aforesaid decision is directed to
be applied in the year under consideration as facts and circumstances as also objection of the
revenue are similar as raised in that year. Besides, it may be pointed out that decision of the
Tribunal in the case of Legato Systems (supra) has been approved by the Hon'ble Delhi High
Court.
49. In the light of above discussion, the appeal of the assessee is allowed in terms indicated
above.
(DISCLAIMER: Though all efforts have been made to reproduce the order correctly but the access
and circulation is subject to the condition that Taxindiaonline are not responsible/liable for any loss or
damage caused to anyone due to any mistake/error/omissions.)
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(Also see analysis of the Order )

IN THE INCOME TAX APPELLATE TRIBUNAL

ITA NO. 1969/D/2006

MENTOR GRAPHICS (NOIDA) PVT LTD

Dy COMMISSIONER OF INCOME TAX

Shri Vimal Gandhi, President &

Dated : November 2, 2007

Appellant Rep. by : Shri Pawan Kumar and Shayamal Mukherhjee

Per : Shri Vimal Gandhi, President :

"Based on the functional analysis and understanding of the international

This search yielded a list of 373 companies."

8. Thereafter, the taxpayer carried quantitative screening and eliminated 32 companies as

S. Net cost plus

Name of the company Reason for elimination

Telesys Software Ltd. Low employee cost

Name of company Operational Profit %

Name of company OPTC (F.Y. 2001

Total cost of provision of services by the

7.10 Accordingly, an adjustment of Rs. 1,45,73,857/- is to be made to the

vehemently challenged selection of comparables by the TPO, it would only be appropriate to

"The object behind enactment of transfer pricing regulations is to prevent shifting

(a) the specific characteristics of the property transferred or services provided in

"(3) An uncontrolled transaction shall be comparable to an international

taking result of a comparable transaction in comparable circumstances and by

a) a) working capital b) b) adjustment for risk and growth

c) c) adjustment of R&D expenses

"The taxpayer as noted above is providing software development support services

prices, because of the potential for variation of operating expenses across

5.Zigma Software 16.38%

Company Name OP/TC

VGL Softech 6.74%

"1.48 If the relevant conditions of the controlled transactions (e.g. price or

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