S. 92CA — Difference on tangible bearing on costs, price or profit to be given due weightage while comparing controlled & uncontrolled transactions

The assessee, an Indian company (ICO) was engaged in the
business of software development and was a registered STPI eligible for 100% tax
break u/s.10A of the Act. The entirety of turnover of ICO was in favour of its
parent in the USA (USCO). The USCO had assured complete buyback from ICO. USCO
had privity with the ultimate customers and was responsible for all risks
including the risk of credit, marketing risk, recovery risk, inventory risk,
warranty risk, foreign exchange risk and post-sales risk, etc.

The revenue model of ICO was based on cost plus basis. ICO
recovered mark-up of 5% of all the costs including depreciation which was
provided in the books of ICO based on the US system.

The TPO made addition on the ground that comparable PBIT was
about 16%. For the purpose of determining comparable mark-up, TPO took into
account 20 comparable cases which included two high margin cases where the
profit was 67% and 54%, respectively, as against average of 16%.

There was no dispute on application of TNMM being the most
appropriate method with reference to profit level indicator of PBIT.

Before the ITAT, the assessee claimed adjustment to the
comparable margin determined by the TPO on account of the following factors :

It was also indicated that the parent suffered losses and the
fact that ICO was otherwise eligible for 100% deduction also supported that
there was no motive for transfer pricing evasion. It was also argued by the
assessee that no adjustment was warranted so long as the price charged by the
assessee was within the range of margin of the comparables.

The ITAT accepted the assessee’s claims for adjustments on
account of the factors narrated above.

The ITAT accepted that in application of TNMM, (i) the
differences likely to affect the price, cost charged or paid or the profit in
the open market are to be taken into consideration to make reasonable and
accurate adjustments to eliminate the differences having material impact; (ii)
if the differences are not capable of being evaluated, the comparables may need
to be ignored.

The ITAT confirmed that Rule 10B as also OECD Guidelines
specifically required suitable adjustments for differences on account of FAR and
other relevant factors. The ITAT also relied on decision of Delhi Tribunal in
the case of Mentor Graphics (Noida) Pvt. Ltd. v. DCIT, (109 ITD 101) to
support that determination of arm’s-length price, functional profile, assets and
assumed risk of controlled and uncontrolled transactions (FAR analysis) need to
be appropriately screened and adjusted for the purpose of making them
comparable.

The ITAT relied on US IRS manual on transfer pricing
provisions which supported adjustments to be made to uncontrolled transactions
to make them comparable.

The ITAT also noted that from out of 20 comparables
considered by the TPO, there were two comparables with high profitability of 54%
and 68% as against the average of 16% and that such extreme cases needed special
consideration. For this ITAT relied on OECD Guidelines :

Para 1.47 of OECD guidelines is to the following effect :