ITAT Modifies Transfer Pricing Adjustment: Functional Dissimilarity Key to Comparable Company Exclusion - 2025-03-07

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ITAT Bengaluru Bench Partially Allows Appeal, Revising Transfer Pricing Adjustments Based on Functional Comparability

Bengaluru, India – The Income Tax Appellate Tribunal (ITAT), Bengaluru Bench, has delivered a split verdict in an appeal concerning transfer pricing adjustments for a software development company providing services to its Associated Enterprises (AE). The tribunal, presided by Accountant Member Manjunatha G, partly allowed the assessee's appeal, modifying the list of comparable companies used to determine the Arm’s Length Price (ALP) of international transactions.

Case Background

The appeal challenged a final assessment order dated October 16, 2019, issued by the Assessing Officer (AO) under Section 143(3) r.w.s. 144C(13) of the Income Tax Act, 1961. This order followed directions from the Dispute Resolution Panel (DRP) concerning transfer pricing adjustments proposed by the Transfer Pricing Officer (TPO).

The appellant company, engaged in software development and management services for gaming software, had its transfer pricing study rejected by the TPO. The TPO conducted a fresh study, selecting different comparable companies and proposing a significant upward adjustment to the assessee's income. The DRP granted partial relief, leading to a final assessment order that the assessee contested before the ITAT.

Assessee's Arguments and Tribunal's Deliberations

The core of the dispute revolved around the selection of comparable companies for benchmarking the ALP of the assessee's software development services. The assessee contested the inclusion of certain companies chosen by the TPO and DRP, and sought the inclusion of others that were initially rejected.

Exclusion of Comparables:

The assessee argued for the exclusion of Tata Elxsi Limited , Persistent Systems Limited , Infosys Limited , and Mindtree Limited from the list of comparables. The primary ground for exclusion was functional dissimilarity.

• Tata Elxsi Limited: The tribunal noted Tata Elxsi's focus on product design and engineering services, substantial R&D expenditure (2.75% of revenue), and significant intangible assets, distinguishing it from the assessee's simple software service provision. Citing a previous ITAT Hyderabad bench decision in the assessee's own case for AY 2010-2011, the tribunal directed the exclusion of Tata Elxsi. The judgment highlighted, "We find that the appellant is a captive service provider to it’s AE on cost plus mark-up basis, whereas, Tata Elxsi Limited is engaged in providing product design and engineering services to different segments of business...Therefore, the said company i.e., Tata Elxsi Limited cannot be comparable to assessee-company."

• Persistent Systems Limited : Similar to Tata Elxsi, the tribunal found Persistent Systems functionally different due to its IP and product business, R&D investments, and intangible assets. The lack of segmental details further hindered comparability. Again, referencing the prior Hyderabad bench decision, Persistent Systems was ordered to be excluded. The tribunal emphasized, " Persistent Systems Limited is engaged in diversified activities, whereas, the assessee company engaged in providing software development services to it’s AE on cost plus mark-up basis as a captive service provider and, therefore, in our considered view, Persistent Systems Limited cannot be compared with the appellant-company."

• Infosys Limited and Mindtree Limited: The tribunal ruled against the inclusion of these companies due to their diversified services beyond routine software development, significant brand value, substantial R&D expenditure, and large scale of operations, making them functionally dissimilar to the assessee. Regarding Infosys, the judgment noted, "Infosys Limited is a giant company carries huge brand value which is evident from the report of brand financials...We further note that the company incurred significant amount of expenditure on R and D activities which is more than the 1000% of the turnover of the appellant-company." For Mindtree, similar observations about diversified services, R&D, and scale were made, also referencing prior ITAT decisions.

Inclusion of Comparables:

The assessee sought inclusion of Akshay Software Technologies Limited , Maveric Systems Limited , and Harbinger Systems Pvt. Ltd.

• Akshay Software Technologies Limited: The tribunal upheld the rejection of Akshay Software due to its high onsite revenue (over 90%) and focus on ERP solutions, which require different expertise compared to the assessee's services.

• Maveric Systems Limited and Harbinger Systems Pvt. Ltd.: In a favorable turn for the assessee, the tribunal directed the inclusion of both Maveric Systems and Harbinger Systems . For Maveric Systems , despite R&D expenditure concerns raised by the Revenue, the tribunal emphasized functional similarity, citing a DRP order from a prior assessment year acknowledging Maveric Systems as functionally comparable. For Harbinger Systems , despite data availability issues cited by the TPO, the tribunal prioritized functional similarity over database presence. The tribunal stated, "Once a particular company is functionally similar to the appellant-company, then such company cannot be rejected on the ground of prowess database/search matrix."

Retention of Comparables:

The tribunal upheld the inclusion of Larsen & Toubro Infotech Limited (L&T) and Cybage Software Private Limited , which were part of the TPO/DRP's comparable set.

• L&T Infotech Limited and Infobeans Technologies Limited: Despite the assessee's arguments for their exclusion, the tribunal sided with the TPO/DRP, finding functional similarities and insufficient evidence to demonstrate significant functional dissimilarities solely based on brand value or intangible assets. For both companies, the tribunal pointed out that the assessee had initially included these in their own TP documentation, weakening their later arguments for exclusion.

Final Decision and Implications

In conclusion, the ITAT Bengaluru Bench partly allowed the assessee's appeal. The tribunal directed the exclusion of Tata Elxsi, Persistent Systems , Infosys, and Mindtree from the list of comparable companies. Conversely, it mandated the inclusion of Maveric Systems and Harbinger Systems , while upholding the inclusion of L&T Infotech and Cybage Software and exclusion of Akshay Software .

This decision underscores the critical role of functional comparability in transfer pricing analysis and highlights the importance of detailed examination of comparable companies' business activities, R&D expenditure, brand value, and scale of operations when determining ALP under the Income Tax Act. The judgment provides valuable guidance on the application of comparability principles in the software development services sector. ```