Honeywell Automation India Ltd., Pune vs Assessee

M/s Honeywell Automation India Limited, 56/57, Hadapsar Industrial Estate, Hadapsar, Pune - 411 013. PAN : AAACT3904F .... Appellant

Vs.

Dy. Commissioner of Income Tax, Circle 7, Pune. .... Respondent

Assessee by : Mr. Percy Pardiwalla & Mr. Venkat Raman Iyer Department by : Mr. Ajit Korde

ORDER

PER G. S. PANNU, AM

The captioned appeal has been preferred by the assessee pertaining to

the assessment year 2006-07, which is directed against the order of the

Dy. Commissioner of Income Tax, Circle 7, Pune (in short 'the Assessing

Officer') passed u/s 143(3) r.w.s. 144C(13) of the Income Tax Act, 1961

(in short "the Act") dated 25.11.2010, which is in conformity with the directions

given by the Dispute Resolution Panel, Pune (in short 'the DRP') dated

29.09.2010.

2. In this appeal, the Grounds of Appeal raised by the assessee read as

under: -

"Based on the facts and circumstances of the case, Honeywell Automation India Limited (hereinafter referred to as the 'Appellant') respectfully craves leave to prefer an appeal against the order passed by the Deputy Commissioner of Income Tax, Circle - 7 ('AO') in pursuance of the directions issued by Dispute Resolution Panel ('DRP'), Pune, dated 29 September 2010 under section 253 of the Income-tax Act, 1961 ('Act') on the following grounds, which are without prejudice to each other:

2 ITA No.18/PN/2011 On the facts and in the circumstances of the case and in law, the Hon'ble DRP and consequentially the learned AO has:

General

1. erred in assessing the total income at Rs.746,351,790 as against income of Rs.214,085,274.

Denial of deduction of Rs.286,049,101 under section 10A of the Act

2. erred in recomputing the deduction under section 10A at Rs.77,460,281 as against Rs.363,509,382 claimed by the Appellant, thereby denying deduction under section 10A to the extent of Rs286,049,101;

Invoking the provisions of section 10A(7) read with section 80IA(10) in the Appellant's case

3. erred in invoking the provisions of section 10A(7) read with section 80IA(10) in the Appellant's case, on the ground that transactions between the Appellant and its associated enterprises are arranged to produce more than ordinary profits.

4. failed to appreciate that provisions of section 10A(7) r.w.s 80IA (10) could only be invoked where both the connected parties are taxable in India and there is tax erosion in India due to 'arrangement' between those persons and not otherwise;

Usage of arithmetic mean as per the transfer pricing study report for determination of 'ordinary profits' for the purpose of section 10A(7) read with section 80IA(10)

5. erred in law by adopting the arithmetic mean of operating margins earned by comparable companies as per the transfer pricing study report as benchmark of 'ordinary profits' computed for the purposes of section 10A(7) read with section 80IA(10).

Appellant earning 'more than ordinary profits'

6. erred in concluding that the profits earned by the Appellant are more than ordinary profits from its Software Technology Park ('STP') operations, without appreciating and considering the business model under which the Appellant operates;

7. failed to appreciate that the rates charged by the Appellant to its Associated enterprise ('AE') were comparable with the rates charged to other customers ('non-AE') and the rates charged in earlier years;

8. should have appreciated that the Appellant has offered to tax similar level of profits in earlier and later years and hence the Appellant could not be considered as have earned 'more than ordinary profits' during the year under appeal;

9. failed to appreciate that the onus is on the Department to prove with substantial evidences that the business of the Appellant is 'arranged' so as to have supernormal profits and mere inferences without substantiating the allegations would not suffice;

Computation of operating margins of the Appellant

10. erred in computing the operating margins earned by the Appellant (from its STP operations) without considering travel, and other costs 3 ITA No.18/PN/2011

reimbursed by its customers as a part of its operating cost and operating income.

Disallowance of provision for expenses amounting to Rs.17,200,000

11. erred in disallowing the provision in respect of 'C' forms not received and sales tax set off, on the ground that the same are governed by the provisions of section 43B of the Act, without appreciating that the same represented ascertained liability towards claims which may not be available Transfer Pricing adjustment under provisions of Chapter X of the Act in respect of international transactions under the system integration segment of the Appellant, with its Associated Enterprises (hereinafter referred to as "AEs") aggregating Rs.229,017,412.

12. On the facts and in the circumstances of the case and in law, the learned Transfer Pricing Officer (TPO) and the learned AO under directions issued by the Hon'ble DRP, erred in making an addition to the Appellant's total income of Rs.229,017,412 based on the provisions of Chapter X of the Act.

13. On the facts and in the circumstances of the case and in law, the learned TPO erred and the Hon'ble DRP further erred in upholding / confirming the action of the TPO rejecting the segmental profit and loss account prepared by the Appellant in respect of IS-Infra segment and Balance System Segment of the Appellant.

14. On the facts and in the circumstances of the case and in law, the learned TPO erred and the Hon'ble DRP further erred in upholding / confirming the action of the TPO of disregarding the fact that during the year under consideration, the assessee had provided for an extraordinary expense item being bad debts/ provision for bad and doubtful debts in its books of accounts amounting to 2.45% of operating cost and accordingly the learned TPO erroneously benchmarked the net profit obtained in the international transactions of the IS-Infra segment and Balance System Segment after including the said extraordinary items in the calculation of the said net profit.

15. On the facts and in the circumstances of the case and in law, the learned TPO erred and the Hon'ble DRP further erred in upholding / confirming the action of the TPO of disregarding the benchmarking analysis and comparable companies selected by the Appellant based on the contemporaneous data in the transfer pricing study report maintained as per section 92D of the Act read with Rule 10D of the Income-tax Rules, 1962 ('the Rules') and the various submissions made by the Appellant in this regard.

16. On the facts and in the circumstances of the case and in law, the learned TPO erred and the Hon'ble DRP further erred in upholding / confirming the action of the TPO of selecting only those companies as 'comparable companies' having bad debt as separate line item in its financial statements.

17. On the facts and in the circumstances of the case and in law, the learned TPO erred and the Hon'ble DRP further erred in upholding / confirming the action of the TPO in making adjustment on the shortfall in the margin of the Appellant on total transactions (i.e. controlled as 4 ITA No.18/PN/2011

well as uncontrolled) instead of applying the shortfall in the margin only to controlled transactions."

3. The substantive dispute in this appeal is manifested by the abovestated

Ground of Appeal Nos.2 to 10, which relates to the quantum of deduction

allowable to the assessee under the provisions of section 10A of the Act.

Although, assessee has raised multiple Grounds of Appeal on this aspect but

the sum and substance of the dispute relates to the quantification of deduction

allowable to the assessee u/s 10A of the Act with respect to the profits derived

from the export of engineering/software services.

4. The appellant-company is, inter-alia, engaged in the export of IT

enabled engineering/software services to its associated enterprise abroad as

well as to the non-related parties. The services are rendered from three units,

which are duly registered with Software Technology Park of India (STPI)

authorities. Out of the three units, two of them, namely, STPI-I & STPI-II are

located at Pune and the third unit is located at Chennai. The profits derived by

the aforesaid three units are entitled for deduction u/s 10A of the Act and

accordingly, assessee claimed deduction amounting to Rs.36,36,09,382/- with

respect to the profits of the aforesaid three units. The details of such claim

have been noted by the Assessing Officer in para 2.5 of his order whereby the

claim of deduction u/s 10A of the Act in respect of STPI Unit-I was

Rs.30,75,65,637/-; with respect to the STPI Unit-II was Rs.1,52,11,386/-; and,

with respect to the STPI Unit, Chennai was Rs.4,07,32,359/-.

5. In-principle, the Assessing Officer has not disputed the entitlement of

the assessee for the claim of deduction u/s 10A of the Act. So however, the

deduction u/s 10A of the Act has been restricted to Rs.7,74,60,281/- as

against the claim of Rs.36,35,09,382/- above thereby denying the deduction to

the extent of Rs.28,60,49,101/-. The aforesaid action of the income-tax 5 ITA No.18/PN/2011

authorities is based on the provisions of section 10A(7) r.w.s. 80-IA(10) of the

Act. As per the Assessing Officer, the profits in relation to section 10A Units

are more than the 'ordinary profits' and therefore he has restricted such profits

for the purposes of the deduction u/s 10A(7) of the Act to the amount of profits,

which he considered as 'reasonably deemed' to have been derived therefrom

in terms of section 10A(7) r.w.s. 80-IA(10) of the Act. Notably, the assessee

had rendered software engineering services from its STPI Units to its

associated enterprises which were in the nature of international transactions

within the meaning of section 92B of the Act. In its Transfer Pricing Study,

assessee had benchmarked the aforesaid international transactions by

selecting the Transactional Net Margin (TNM) Method as the most appropriate

method. On the basis of the profit margin in respect of 10A Units which was

substantially higher than the average of the margin of comparables selected

by it, it was seen that the stated value of the international transactions of

software engineering services segment did not require any adjustment vis-à-

vis the arm's length price. The TPO on a reference by the Assessing Officer

passed an order u/s 92CA(3) of the Act dated 12.10.2009 accepting the

aforesaid position with respect to the software engineering services segment.

The Assessing Officer was of the view that the profit margin in respect of the

10A Units was substantially higher than the margin of the comparables chosen

by the assessee while carrying out the comparability analysis under the TNM

Method and therefore according to him, the profits declared by the assessee in

the 10A Units were not the ordinary profits and that they should be restricted

to the ordinary profits in such business based on the margins of the

comparables selected by the assessee itself. The operating profit margin of

the comparables was taken by the Assessing Officer at 17.06% after the

adjustment directed by the Dispute Resolution Panel (i.e. DRP) and after

comparing it with the assessee's margin of 10A Units of 80.06%, the profits in

excess of the operating profit margins of the comparables was considered as 6 ITA No.18/PN/2011

more than ordinary profits declared by the assessee, which was computed at

Rs.28,60,49,101/-. In this manner, the Assessing Officer determined the

ordinary profits, which according to him, was reasonably deemed to have been

derived from the business of 10A Units at Rs.7,74,60,281/- as against

Rs.36,35,09,382/- declared by the assessee. Hence, the deduction u/s 10A of

the Act was restricted to Rs.7,74,60,281/- as against Rs.36,35,09,382/- based

on the operating profit margin of the comparables selected by the assessee in

the TNM Method while carrying out the Transfer Pricing Study.

6. In the above background, the rival parties have made their submissions

in extenso. The rival submissions have been heard and the relevant material

and record perused.

7. Before proceeding further, we may briefly touch-upon the relevant

provisions of the Act, which have a bearing on the controversy before us.

Sub-section (7) of section 10A of the Act reads as under :-

"(7) The provisions of sub-section (8) and sub-section (10) of section 80-IA shall, so far as may be, apply in relation to the undertaking referred to in this section as they apply for the purposes of the undertaking referred to in section 80-IA."

8. Further, sub-sections (8) and (10) of section 80-IA of the Act referred to

in section 10A(7) read as under :-

"(8) Where any goods [or services] held for the purposes of the eligible business are transferred to any other business carried on by the assessee, or where any goods [or services] held for the purposes of any other business carried on by the assessee are transferred to the eligible business and, in either case, the consideration, if any, for such transfer as recorded in the accounts of the eligible business does not correspond to the market value of such goods [or services] as on the date of the transfer, then, for the purposes of the deduction under this section, the profits and gains of such eligible business shall be computed as if the transfer, in either case, had been made at the market value of such goods [or services] as on that date :

Provided that where, in the opinion of the Assessing Officer, the computation of the profits and gains of the eligible business in the manner hereinbefore 7 ITA No.18/PN/2011

specified presents exceptional difficulties, the Assessing Officer may compute such profits and gains on such reasonable basis as he may deem fit. [Explanation.--For the purposes of this sub-section, "market value", in relation to any goods or services, means the price that such goods or services would ordinarily fetch in the open market.] (9) xxxxxxxxxx (10) Where it appears to the Assessing Officer that, owing to the close connection between the assessee carrying on the eligible business to which this section applies and any other person, or for any other reason, the course of business between them is so arranged that the business transacted between them produces to the assessee more than the ordinary profits which might be expected to arise in such eligible business, the Assessing Officer shall, in computing the profits and gains of such eligible business for the purposes of the deduction under this section, take the amount of profits as may be reasonably deemed to have been derived therefrom."

9. Section 10A of the Act is a special provision in respect of newly

established undertakings in free trade zone, etc.. Section 10A postulates a

deduction of such profits and gains as are derived by an undertaking from the

export of articles or things or computer software for a period of ten

assessment years beginning with the assessment year relevant to the

previous year in which the undertaking begins to manufacture or produce such

articles or things or computer software, as the case may be, while computing

the total income of an assessee. Shorn of other details, for the present it

would suffice to note that the three units of the assessee, namely, Unit No.I &

II at Pune and Unit at Chennai are recognized as STPI Units in accordance

with the Software Technology Park Scheme of the Government of India and

they are eligible for the benefits of section 10A of the Act.

10. The bone of contention in the present case between the assessee and

the Revenue is invoking of section 10A(7) r.w.s. 80-IA(10) of the Act. Section

80-IA(10) of the Act, reproduced above, empowers the Assessing Officer to re-

compute the profits and gains of the eligible business for the purposes of

deduction u/s 10A of the Act if it appears to him that the profits declared by the

assessee are more than the ordinary profits which might be expected to arise

in such an eligible business. So however, the aforesaid power of the 8 ITA No.18/PN/2011

Assessing Officer is subject to the pre-requisites contained in sub-section (10)

of section 80-IA of the Act itself. The circumstances in which such a course is

available to the Assessing Officer is contained in section 80-IA(10) itself. A

perusal of section 10A(7) r.w.s. 80-IA(10) of the Act would show that the two

essential conditions are to be established before the Assessing Officer can

proceed to disregard the profits declared by the assessee and determine the

amount of profits which may reasonably deemed to have been derived from

such business. Notably, such conditions are (i) existence of a close

connection between the assessee carrying on eligible business and any other

person; and, (ii) that the course of business is so arranged that the business

transacted produces to the assessee more than the ordinary profits.

11. At the outset, it is to be noted that the opening sentence in section 80-

IA(10) of the Act contains the expression - "where it appears to the Assessing

Officer that ............". This would show that the onus is on the Assessing

Officer to justify invoking of section 10A(7) r.w.s. 80-IA(10) of the Act, having

regard to the facts circumstances of a given case. Evidently, the primary rule

of evidence is that "what is apparent is real" unless proved otherwise by the

person alleging it so. Ostensibly, if the Assessing Officer is to invoke the

provisions of section 10A(7) r.w.s. 80-IA(10) of the Act then the onus is on him

to justify such invocation having regard to the cogent material and evidence on

record. On this aspect of the matter, there was no dispute between the rival

counsels inasmuch as the Ld. CIT-DR quite fairly agreed that the onus was on

the Assessing Officer to justify invoking of section 10A(7) r.w.s. 80-IA(10) of

the Act in the facts of a given case. Nevertheless, on this aspect, we may also

make a reference to the judgement of the Hon'ble Karnataka High Court in the

case of CIT vs. H.P. Global Soft Ltd., 342 ITR 263, which was referred to in

the course of hearing before us. In the case before the Karnataka High Court,

the issue was similar inasmuch as therein, the Assessing Officer had invoked 9 ITA No.18/PN/2011

the provisions of section 80-I(9) r.w.s. 10A(6) of the Act while re-determining

the claim of exemption in terms of the then prevailing section 10A(4) of the

Act, and the assessment years were 1995-96 to 1998-99. The provisions of

section 10A(6) r.w.s. 80-I(9) of the Act, which were before the Hon'ble

Karnataka High Court are quite similar to the provisions of section 10A(7)

r.w.s. 80-IA(10) of the Act before us. The Hon'ble Karnataka High Court,

upheld the stand that the requirements of the provisions of section 80-I(9) of

the Act are two-fold, namely that there should be a close connection between

the assessee and the other person, which may be a reason for the assessee

to earn higher profits but, more importantly there should be material to indicate

that assessee had indulged in an arrangement with the other person so as to

produce to the assessee more profits than ordinarily what profits the assessee

might have expected to arise from such business. As per the Hon'ble

Karnataka High Court, it was for the Assessing Officer to indicate any material

or evidence to disclose any such arrangement between the assessee and the

other person. The aforesaid judgement of the Hon'ble Karnataka High Court

justifies the assertion of the assessee before us that the onus for justifying the

invoking of section 80-IA(10) r.w.s. 10A(7) of the Act is on the Revenue based

on cogent material. At this point, we may also make a reference to the

judgement of the Hon'ble Bombay High Court in the case of CIT vs. M/s

Schmetz India Pvt. Ltd. vide Income Tax Appeal No.4508 of 2010 dated

04.09.2012, which is also to the similar effect. In the case before the Hon'ble

Bombay High Court assessee was a wholly owned subsidiary of a German

Company. It had two divisions - one at Kandla in the Kandla Free Trade

Zone, engaged in the manufacture and export of industrial sewing machine

needless; and other at Mumbai, engaged in trading in industrial sewing

machine needless. The manufacturing division at Kandla exported its entire

production of industrial machine needless to its holding company in Germany.

For the assessment year 2004-05 assessee declared an income of Rs.20.54 10 ITA No.18/PN/2011

crores from its manufacturing division at Kandla and claimed 100% deduction

u/s 10A of the Act. During the course of the assessment proceedings,

Assessing Officer was of the view that abnormal profits had been declared in

respect of the Kandla division, only in view of the income therefrom being

exempt u/s 10A of the Act, and that the trading division at Mumbai showed a

loss of Rs.70.29 lacs. The Assessing Officer invoked the provisions of section

10A(7) r.w.s. 80-IA(10) of the Act to hold that profits of Kandla Division were

abnormal profits. The Tribunal disagreed with the Assessing Officer. The

Tribunal, inter-alia, held that the Assessing Officer has not been able to prove

that any arrangement had been arrived between the parties which resulted in

extraordinary profits to the respondent-assessee's manufacturing division at

Kandla. Consequently, the working of the profits by the Assessing Officer was

not approved. The aforesaid action of the Tribunal was upheld by the Hon'ble

Bombay High Court. On this aspect, the Bangalore Bench of the Tribunal in

the case of Digital Equipment India Ltd. vs. DCIT, 103 TTJ 329 (Bang.) has

also held that the conditions of the section have to be objectively satisfied by

the Assessing Officer, based on cogent reasoning and evidence.

12. At the time of hearing, the Ld. Representative for the assessee

vehemently argued that the provisions of section 10A(7) r.w.s. 80-IA(10) of the

Act are inapplicable in the present case because there is no material lead by

the Revenue to say that there was any arrangement between the assessee

and the associated enterprises which produced to the assessee more than the

'ordinary profits' within the meaning of section 10A(7) r.w.s. 80-IA(10) of the

Act. According to the Ld. Representative, the transactions of the assessee by

way of rendering software engineering services to its associated enterprises

abroad are not arranged so to yield any extraordinary profits to the assessee.

The Ld. Representative pointed out that assessee was charging the same rate

for services rendered to associated enterprises as well as to the non-related 11 ITA No.18/PN/2011

parties. The details of rates charged by the assessee to the third parties vis-à-

vis the related parties have also been placed in the Paper Book along with

sample copies of invoices raised on the and non-related parties. It was also

pointed out with reference to the submissions made to the Assessing Officer,

which have been reproduced in para 2.6 of the assessment order, that the

assessee has continued to charge similar rates even after the tax holiday

period of STPI Unit had ended.

13. At the time of hearing, it was explained that the tax holiday u/s 10A of

the Act was available for Unit No.I at Pune upto assessment year 2007-08;

that for Unit No.II at Pune upto assessment year 2011-12; and, that for

Chennai Unit upto assessment year 2009-10. A statement showing operating

margins to total cost earned by the assessee from the STPI Units relatable to

the software engineering services segment was furnished to show that even

after the expiry of the tax holiday period the profits of the Units is higher than

the other Units of the assessee.

14. In this context, a reference has also been made to the commercial

reasons explained before the Assessing Officer for the high profits earned by

the assessee's STPI Unit. From the submissions furnished to the Assessing

Officer, which have been reproduced in para 2.6 of the assessment order, it is

revealed that reasons were advanced to justify the higher margins of the STPI

Units. Firstly, it was contended that there was substantial cost savings in

terms of costs on sales, marketing, sale promotion and advertisement

because majority of the business in the engineering services segment was

with affiliates only. Secondly, it was pointed out that assessee is in the

business of IT enabled services rendering engineering consultancy services in

execution of industrial automation and building automation and control projects

and it does not incur much product development costs or investments which 12 ITA No.18/PN/2011

are usually incurred by other software companies. Thirdly, it was pointed out

that the salary levels in the case of the assessee are much lower than other

software companies because assessee was hiring electronics and process

engineering Graduates/Diploma holders and not software professionals. It is

also pointed out that assessee has a lower rate of idle staff as it works mostly

on in-house Honeywell Technology and therefore the productivity of the

employees is much higher than other software companies. Further, it was

also pointed out that assessee was reimbursed all the costs, like foreign travel

and living expenses incurred abroad by its employees in the course of

rendering engineering/software services. Assessee was also reimbursed

incidental expenses incurred by it viz. visa costs, work permit costs, etc. and

therefore the cost of sales was on lower side, as a result of which the

percentage of Operating profit to total cost shows a higher percentage,

although the impact on profit remains unaltered. All these points, which were

raised before the Assessing Officer, have been reiterated before us to show

that the higher profits are not attributable to any arrangement with associated

enterprises but due to business reasons.

15. Apart therefrom, it has also been pointed out that assessee is a public

limited company listed on the stock-exchange wherein the overseas

Honeywell entities owned 81.24% of shareholding and the public shareholding

is to the extent of 18.76%. It was pointed out that initially TATA group was

also owning shares in the assessee company to the extent of 40% and

Honeywell entities held 41% and the balance 19% was held by the public.

This pattern had changed from November, 2004 onwards when the TATA

group gave up its shareholding in the assessee company. On the basis of the

aforesaid shareholding pattern, a plea setup by the assessee is that if there

was any manipulation of profits by assessee charging higher rates to its

overseas Honeywell group entities resulting in shifting of profits from overseas 13 ITA No.18/PN/2011

entities to the assessee-company, it would not be a prudent exercise by the

Honeywell group because it does benefit the Honeywell group as a whole.

Since there is a significant public shareholding in the assessee company, it

would mean that the any extraordinary benefit passed on by overseas

Honeywell group entities to assessee would result in a loss for Honeywell

group on an overall basis to the extent of public shareholding in the assessee

company. It was, therefore, contended that in such a scenario, it could not be

said that there was any arrangement between the assessee and the overseas

Honeywell entities to produce higher profits to the assessee. In support of

such proposition, reliance has been placed on the decisions of the Mumbai

Bench of the Tribunal in the case of ITO vs. Zydus Nycomed Healthcare (ITA

Nos.4013/Mum/208, 4206/Mum/2009 and 4343/Mum/2009 dated 31.10.2013).

16. Apart from the aforesaid, it has been vehemently argued that ordinary

profits for the purposes of section 10A(7) r.w.s. 80-IA(10) of the Act cannot be

computed relying upon the Transfer Pricing documents prepared by the

assessee. The Ld. Representative pointed out that having regard to the

intention of the Transfer Pricing Provisions, the margins determined under the

TNM Method are to be taken as indicative of the least profits that must be

retained in India and it cannot be used to benchmark the 'ordinary profits' as

referred to in section 10A(7) r.w.s. 80-IA(10) of the Act. The sum and

substance of the plea setup by the assessee is that the legislative intent

behind the Transfer Pricing Provisions is different from the intent behind

section 10A(7) r.w.s. 80-IA(10) of the Act.

17. The Ld. CIT-DR has made detailed submissions in support of the

invoking of section 10A(7) r.w.s. 80-IA(10) of the Act in the present case. The

Ld. CIT-DR submitted that section 80-IA(10) of the Act placed much lighter

burden of proof on the Assessing Officer because of the presence of the 14 ITA No.18/PN/2011

expression "it appears" in section 80-IA(10) of the Act. According to the Ld.

CIT-DR, section 80-IA(10) can be invoked by the Assessing Officer when 'it

appears' to him, and it is not subject to the Assessing Officer's belief or

satisfaction as is the case with invoking of section 147/148, etc.. The following

portion of section 80-IA(10) of the Act was emphasized "...........the Assessing

Officer shall, in computing the profits and gains of such eligible business for

the purposes of the deduction under this section, take the amount of profits as

may be reasonably deemed to have been derived........." to say that it does

not require the Assessing Officer to precisely determine the eligible profits, but

only a prima-facie satisfaction about presence of more than the ordinary profits

would suffice. It is sought to be emphasized that because of the presence of

the words ".......as may be reasonably deemed to have been derived......." in

section 80-IA(10) of the Act, a much lighter burden of proof is put on the

Assessing Officer for computing tax avoidance. As per the Ld. CIT-DR, similar

to the Transfer Pricing Provisions, the said Provision does not require a

precise accuracy on the part of the Assessing Officer. At this point, the Ld.

CIT-DR relied upon the decision of the Hon'ble Kerala High Court in the case

of Abdul Vahab P. vs. ACIT, (2012) 249 CTR 102 (Kerala) wherein the word

"appears" has been understood to imply a 'prima-facie' satisfaction of the

Assessing Officer. Therefore, it is sought to be made out that a prima-facie

satisfaction of the Assessing Officer is enough to apply the provisions of

section 10A(7) r.w.s. 80-IA(10) of the Act.

18. It is further submitted that the word "arrangement" used in section 80-

IA(10) of the Act is to be understood as any agreement with the associated

enterprise and in support of the same reliance has been placed on the

decision of the Hon'ble Bombay High Court in the case of Bank of India Ltd.

vs. Ahmedabad Manufacturing & Calico, (1972) 42 CompCas 211 (BomXDPB-

p-42), wherein it has been held as under :-

15 ITA No.18/PN/2011

"The word "arrange" has, as one of its meaning, in the Shorter Oxford Dictionary, edition, "to come to an agreement or understanding", and the word "arrangement" has, as its primary meaning, "the action of arranging". As a matter of plain language it would, therefore, follow that the term "arrangement"

means any agreement or understanding between the parties concerned."

19. As per the Ld. CIT-DR, since there is an agreement between the

assessee and the associated enterprises for Provision of IT enabled

engineering/software services, it is to be understood as an "arrangement"

within the meaning of section 80-IA(10) of the Act. According to him, the

requirements of section 80-IA(10) of the Act are satisfied if there exists an

arrangement which leads to production of more than ordinary profits.

Therefore, according to him, in the present case, the Assessing Officer is

justified to invoke section 10A(7) r.w.s. 80-IA(10) of the Act inasmuch as the

profit margin of the assessee's STPI Units is 80.06% as against 17.06% of the

comparable selected by the assessee itself in its Transfer Pricing Study. As

per the Ld. CIT-DR, when the arrangement has led to resulting into more than

ordinary profits, necessary condition for invoking section 80-IA(10) of the Act is

satisfied.

20. Apart from the aforesaid submissions, the Ld. CIT-DR has made other

pleas also to justify the restriction of deduction u/s 10A of the Act. In this

context, he has pointed out that even the Safe Harbor Rules issued by the

CBDT with respect to the Transfer Pricing assessment provide for 20%

operating profit as an acceptable profit in IT enabled services segment and

therefore that was a good benchmark as to what constitutes 'ordinary profits'

in the assessee's impugned line of business. The Ld. CIT-DR also made a

submission that even if the computation of excess profits done by the

Assessing Officer based on the margin of the comparable is not found to be a

good methodology, yet the failure of computation process by the Assessing

Officer would not vitiate the invoking section 10A(7) r.w.s. 80-IA(10) of the Act 16 ITA No.18/PN/2011

in the present case. The excess profits according to him can be computed by

an appropriate method by remanding the matter back to the file of the

Assessing Officer. In any case, it has been contended section 80-IA(10) of the

Act requires computing of 'more than ordinary profits' in the eligible business.

Comparable companies are in the same line of the business and having

similar functions performed, assets employed and risks assumed as the

assessee, therefore, comparable companies are carrying on eligible business,

and thus the profits margin of comparable reflect ordinary profits.

21. With regard to the assessee's plea that even after the expiry of section

10A benefits, assessee was declaring healthy profits, the Ld. CIT-DR pointed

out that what matters in future years is the actual amount of the taxes paid

and not merely the profits generated in the Unit. It was also contended that

the fact that assessee has rendered services to the non-related parties at the

same rates is also not relevant for the purposes of application of section

10A(7) r.w.s. 80-IA(10) of the Act. It was also submitted by him that fact of the

assessee being reimbursed the travelling costs, etc. cannot be responsible for

assessee's high profit which are not of an ordinary level. The Ld. CIT-DR

pointed out that if certain part of the expenditure is being incurred by the other

parties then the cost of such expenditure would certainly be reduced from the

price charged by the assessee for the services rendered. In any case, it is

pointed out that reimbursement of expenses is a profit neutral transaction and

does not impact the profitability of the assessee.

22. Before we proceed further, it would be appropriate to examine the

scope and intent of the provisions of section 10A(7) r.w.s. 80-IA(10) of the Act.

In this context, a reference has been made to the CBDT Circular No.308 dated

29.06.2008 wherein the reasons for introduction of sub-section (7) to section 17 ITA No.18/PN/2011

10A of the Act has been explained. In-particular, reference has been made to

the following contents of the Circular :-

"The provisions of sub-section (8) and sub-section (9) of section 80-I will also apply in relation to the industrial undertaking referred to in the new section 10A as they apply in relation to an industrial undertaking referred to under section 80-I. Under the applied sub-section (8) of section 80-I, it is provided that where an Assessee has several units, some in the free trade zone and some outside, the profits of the unit in the free trade zone will be computed after taking the cost of the goods transferred to or from the unit on the basis of the market value of such goods. The applied sub-section (9) of section 80-I empowers the Income-tax Officer to determine the reasonable profits that could be attributed to the qualifying undertaking in the free trade zone in cases where, owing to the close connection between the Assessee and any other persons or for any other reason, the course of the business is so arranged that the industrial undertaking set up in the free trade zone derives more than ordinary profits which may be expected to arise in that business. This provision has been made with a view to avoiding abuse of the new tax concessions by manipulation of profits between associate concerns or different units of the same concern."

[underlined for emphasis by us]

23. Quite clearly, the provisions of section 10A(7) of the Act intend to plug

abuse of tax concession by manipulation of profits between associated

concerns or between different units of the same concern. The objective of the

aforesaid Provision is that the tax concessions are not abused by manipulation

of profits. In our considered opinion, the aforesaid explanation in the CBDT

Circular (supra) signifies the legislative intent and it is also manifested in the

language of section 10A(7) r.w.s. 80-IA(10) of the Act. We say so for the

reason that the phraseology of section 80-IA(10) of the Act itself suggests that

the profits and gains of an eligible business cannot be tinkered with by the

Assessing Officer merely because they are more than the ordinary profits or

that they are quite high. The existence of substantial or more than ordinary

profits by itself does not sufficiently empower the Assessing Officer to

disregard them and determine the profits which he may consider to be

reasonably deemed to have been derived therefrom. The presence of the

expression "the course of business ............ is so arranged ............. that the

business transacted ............... produces to the assessee more than ordinary 18 ITA No.18/PN/2011

profits" is significant and its understanding has to be prefaced by the

legislative objective of plugging abuse of the tax concessions granted u/s 10A

of the Act by manipulation of profits between associated parties. In other

words, the import of the expression "so arranged" has to be read in

conjunction with the legislative intent that there should not be any abuse of tax

concession by manipulation of profits. Therefore, section 10A(7) r.w.s. 80-

IA(10) of the Act can be invoked only where it is shown that the course of

business is so arranged which reflects an abuse of tax concession whereby

the business transacted between two entities is so arranged, which produces

to the assessee more than the ordinary profits which might be expected to

arise in such eligible business. The emphasis is to eschew those 'more than

the ordinary profits' which are as a result of a business between two closely

connected concerns having been arranged with the intent of abuse of the tax

concession. Ostensibly, in the present case, the Revenue would have to

justify that the course of business between assessee and the associated

enterprises has been 'so arranged' which produces to the assessee more than

the ordinary profits which might be expected to arise in such eligible business

with the intention of abusing the tax concession granted in section 10A of the

Act. The mere existence of (i) a close connection between the assessee and

the other person; and, (ii) more than ordinary profits is not sufficient to justify

invoking of section 80-IA(10) of the Act in the absence of there being any

material to say that the course of business between them is "so arranged" to

abuse the tax concessions granted u/s 10A of the Act by manipulating profits

between associated persons. Ostensibly, the same is required to be

demonstrated on the basis of a cogent material and evidence. In other words,

the presence of the expression "so arranged" has to be understood in the

context of the abuse of tax concession which is sought to be plugged by the

provisions of section 10A(7) r.w.s. 80-IA(10) of the Act. 19 ITA No.18/PN/2011

24. On this aspect, the Ld. CIT-DR had vehemently argued, based on the

judgement of the Hon'ble Bombay High Court in the case of Bank of India Ltd.

(supra) that the meaning of the word "arranged' in section 80-IA(10) of the Act

has to be understood to mean an agreement or an understanding between the

parties concerned. The relevant portion of the decision of the Hon'ble Bombay

High Court has been reproduced in the earlier part of this order, according to

which, it is said that the term arrangement in plain language means any

agreement or understanding between the parties concerned. On this basis,

the Ld. CIT-DR submitted that undeniably there is an agreement between the

assessee and the associated enterprises whereby the services have been

provided by the assessee to them and therefore the same is to be understood

as an "arrangement" within the meaning of section 10A(7) r.w.s. 80-IA(10) of

the Act. Along with the aforesaid, it has also been emphasized, on the basis

of the language of section 80-IA(10) of the Act that, the Assessing Officer is

not required to be prove that there is an arrangement for producing more than

ordinary profits. Whereas, as per the Ld. CIT-DR, section provides that

arrangement leading to production of more than ordinary profit will satisfy the

necessary condition of section 80-IA(10) of the Act. Thus, according to the Ld.

CIT-DR, in the instant case there is an arrangement and it has lead to

production of more than the ordinary profits. According to the Ld. CIT-DR, the

meaning of the words "so arranged" in section 80-IA(10) of the Act only seeks

to ensure that there was an agreement between the assessee and associated

enterprise.

25. We have carefully examined the aforesaid contentions of the Ld. CIT-

DR. In our considered opinion, the import of the expression "arranged" in

section 80-IA(10) of the Act is not to be understood in its plain language but

the same has to be understood in the context in which it is placed in the

section. Notably, section 80-IA(10) of the Act restricts the plain meaning of the 20 ITA No.18/PN/2011

term "arranged" because it is placed between the words "........the course of

business between them is so arranged that the business transacted between

them produces to the assessee more than the ordinary profits which might be

expected to arise in such eligible business........." . Therefore, it would

necessarily mean that the 'arrangement' referred to is an arrangement of the

course of business which produces to the assessee more than the ordinary

profits with the intent of abusing the tax concession. Thus, the word

"arranged" in the section does not envisage a simple arrangement, but a

arrangement of "the course of business transacted" which produces to the

assessee more than ordinary profits which might be expected to arise in such

a business with the intent of abusing the tax concessions. Therefore, the

meaning of the words "so arranged" have to be understood in the context in

which they are placed in section 80-IA(10) of the Act. A mere agreement

between the assessee and the associated enterprises for transacting business

is not enough to invoke section 80-IA(10) of the Act.

26. In-fact, even the Hon'ble Bombay High Court in the case of Bank of

India Ltd. (supra) has also appreciated the contextual meaning of the

expression "arrangement". The issue before the Hon'ble Bombay High Court

was with regard to the scheme of re-construction or arrangement contained in

section 391(1) of the Companies Act, 1956. In the context of section 391(1) of

the Companies Act, 1956, the Hon'ble High Court was dealing with the

meaning of the word "arrangement". After having explained the meaning of

the term arrangement in plain language, which we have referred earlier, the

Hon'ble High Court went on to say as under in the context of the word

"arrangement" qua section 391(1) of the Companies Act, 1956 :-

"Section 391(1), however, in any opinion somewhat restricts this otherwise unlimited import of the term "arrangement" in so far as the said section applies only to an agreement or understanding between the company and its creditors or any class of them, or between the company and its members or any class 21 ITA No.18/PN/2011

of them, or between the company and its members or any class of them, which would necessarily mean that it must be an agreement or understanding which affects their rights"

[underlined for emphasis by us]

27. The aforesaid clearly points out that the Hon'ble High Court imparted

meaning to the word "arrangement" in the context of section 391(1) of the

Companies Act, 1956 to mean that it must be an agreement or understanding

which affects the rights between the company and its creditors or any class of

them and between the company and its members or any class of them. By the

same analogy in the present context, we have to understand the meaning of

the expression "as arranged" in section 10A(7) r.w.s. 80-IA(10) of the Act to

mean a situation whereby the course of business has been so arranged that

the business transacted produces to the assessee more that the ordinary

profits with an intent to abuse the tax concessions granted in section 10A of

the Act. Moreover, if one is to understand the import of the expression "so

arranged" in section 80-IA(10) of the Act as canvassed by the Ld. CIT-DR, it

would mean that for the purposes of fulfillment of the conditions prescribed in

section 10A(7) r.w.s. 80-IA(10) of the Act, existence of mere close connection

and more than the ordinary profits would suffice. In other words, as per the

Revenue, the existence of close connection and high profits would lead to a

presumption that there is an "arrangement" within the meaning of section 80-

IA(10) of the Act. The aforesaid plea, in our view, not only belies the language

of section 80-IA(10) but also the legislative intent which seeks to curtail the

abuse of tax concession by manipulation of profits between associated

concerns. Therefore, an arrangement which is referred to in section 10A(7)

r.w.s. 80-IA(10) of the Act has to be one which is prefaced by an intention to

abuse the tax concessions, as per the intendment of the legislature.

Therefore, existence of a mere agreement to do business is not enough to

fulfill the requirement of section 10A(7) r.w.s. 80-IA(10) of the Act in the

context of the words "the course of business between them is so arranged". 22 ITA No.18/PN/2011

28. At this stage, we may also address the argument of the Ld. CIT-DR that

the burden cast on the Assessing Officer in section 10A(7) r.w.s. 80-IA(10) of

the Act is much lighter and even a prima-facie satisfaction of an existence of

tax avoidance is sufficient. In this context, we may refer to the decision of the

Bangalore Bench of the Tribunal in the case of Digital Equipment India Ltd.

(supra), wherein similar argument from the side of the Revenue has been

addressed. The Bangalore Bench of the Tribunal was dealing with invoking of

section 10A(6) r.w.s. 80-I(9) of the Act for assessment year 1995-96, which

are pari-materia to section 10A(7) r.w.s. 80-IA(10) of the Act invoked by the

Revenue before us. The following discussion is relevant :-

"The requirements under the section are :

(a) There must be a close connection between the appellant and other person.

(b) The course of business between them should be so arranged that it produces to the appellant more than the ordinary profits from such business.

To satisfy the above test the AO has to adduce evidence and reasons cogently and the same is open to verification by the appellate authorities. The primary rule of evidence is that "what is apparent is real" unless proved otherwise by the person alleging it otherwise. The manner of satisfaction outlined in the section should be based on evidence and not on surmise or suspicion. The question is not whether the onus is light or heavy but whether the AO has discussed objectively the conditions mentioned in the section to disturb the results declared by the appellant. In this case, the AO has failed to adduce any evidence or reason to satisfy the invoking of s. 80-1(9). First of all, a mere substantial profit does not give rise to any valid view that there could be any arrangement. It is a case of joint venture listed Indian company, where all arrangements are open for scrutiny and acceptance not only by digital group worldwide but also from joint venture partners and shareholders. Digital group overseas will not pay undue sum, which it cannot recoup entirely to exclusion of others. Hence nothing can be arranged to the exclusive benefit of overseas partner. One cannot presume the existence of close connection or possibility of an arrangement for earning more than ordinary profits. In this case the profits earned is comparable with the profits earned by other companies in the same industry. Hence there is no case for further verification. The AO has compared the profit of software unit with that of hardware unit. Thus the foundation itself is on wrong premise. There cannot be comparison between an orange and an apple. It is known fact that profitability of software units is always higher than hardware unit. The test whether the appellant has earned more than ordinary profits, in this case, the answer is obvious NO, even as found by the AO. When the profits earned are reasonable and not excessive, there is no reason to sustain the addition Further there is no evidence of existence of any arrangement as contemplated under s. 80-1(9)."

23 ITA No.18/PN/2011

29. Quite clearly, as per the Tribunal the question is not whether the onus is

light or heavy but whether the Assessing Officer has discussed objectively the

conditions mentioned in the section to disturb the results declared by the

appellant.

30. Now, the case of the Assessing Officer is that the profits derived by the

assessee from the eligible business are more than the ordinary profits and

therefore he is empowered to arrive at what could be a reasonable profit from

such eligible business and such profit be taken as reasonably deemed to have

been derived from the eligible business for the purposes of computing the

deduction u/s 10A of the Act. We find that in the entire assessment order,

there is no material or any evidence which has been brought out to say that

the course of business between assessee and the associated enterprises has

been so arranged that the business transacted has produced to the assessee

more than the ordinary profits.

31. No doubt, there is a close connection between assessee and the

associated enterprises and to that extent section 10A(7) r.w.s. 80-IA(10) of the

Act has been rightly examined by the income-tax authorities. The second

aspect that the course of business was so arranged so as to result in more

than ordinary profits is not at all forthcoming from the order of the Assessing

Officer. There is no material or evidence referred to in the assessment order

to indicate that the course of business has been so arranged so as to inflate

profits with the intent to abuse tax concession u/s 10A of the Act. At this point,

we may make a reference to the stand of the Assessing Officer that the

operating profit margins of the assessee are substantially higher than the

average operating margin of the comparables selected by the assessee in its

Transfer Pricing Study. This has formed the basis for the Assessing Officer to

say that assessee has earned more than ordinary profits which might be 24 ITA No.18/PN/2011

expected to arise in such a business. Be that as it may, the aforesaid is not

enough to say that the course of business has been so arranged to result in

more than ordinary profits. However, from the side of the Revenue, it was

pointed out that the Transfer Pricing comparability analysis itself suggests that

the profit margins of the assessee are more than the ordinarily accepted

margin in this line of business. The moot question is as to whether the same

can be considered as a material to indicate that the course of business

between the assessee and the associated enterprises has been so arranged,

so as to result in 'more than the ordinary profits' within the meaning of section

10A(7) r.w.s. 80-IA(10) of the Act. In this context, we may refer to the decision

of the Chennai Bench of the Tribunal in the case of Visual Graphics

Computing Services India (P) Ltd. vs. ACIT, 148 TTJ 621 (Chennai), wherein

following discussion is relevant :-

"We heard both sides in detail and considered the issue. As far as the present case is concerned, the Transfer Pricing Officer has made a categorical finding that the operating profit reported by the assessee is higher than the profit worked out on the basis of arm's length price. The Transfer Pricing Officer, therefore, concluded that no transfer pricing adjustment is called for in the present case. The Assessing Officer has made the reference to the Transfer Pricing Officer under section 92CA. The reference is made for the purpose of computing income arising from an international transaction with regard to the arm's length price as provided in section 92. Therefore, it is to be seen that the scope and extent of reference made by the Assessing Officer to the Transfer Pricing Officer is confined to the singular purpose stated in section

92. Sections 92A, 92B, 92C, 92CB, 92D, 92E and section 92F are all precisely defining and facilitating provisions ultimately for the purpose of computing the income as stated in section 92. All the above stated sections provided in Chapter X of the Income-tax Act, 1961 belong to a separate code as such, enacted for the purpose of computing income from international transactions having regard to the arm's length price so as to confirm that there is no avoidance of tax by an assessee. Therefore, where in a case, the Transfer Pricing Officer suggests that the operating profit declared by an assessee is compatible to the arm's length price norms and no adjustment is necessary, the operation of all those provisions come to an end. If the, Assessing Officer has to make any other adjustment towards computing deduction available under section 10A, the computation has to be made in the context of section 10A(7) read with section 80-IA(10).

It is clear that in a case of transfer pricing assessment, it has got two segments. The first segment consists of rules and procedures for computing the income other than the income arising out of international transactions with associate enterprise. The second segment consists of rules and procedures in connection with computation of income from international transactions with 25 ITA No.18/PN/2011

associate enterprises on the basis of the arm's length price. The second segment relating to computation of the arm's length price, is a set of rules for the purposes of transfer pricing matters and those procedures and rules can be used only for the purpose serving the object of section 92. When the Transfer Pricing Officer states that there is no need of transfer pricing adjustment, the matter should end there and any other adjustment that the Assessing Officer would like to make with reference to the first segment must be made independent of the order of the Transfer Pricing Office under section 92CA.

To state in simple terms, the transfer pricing regime is different from regular computation of income. Section 10A belongs to that part of regular computation of income and it should be computed independent of transfer pricing regulations and transfer pricing orders. It is not therefore, permissible for the Assessing Officer to work out section 10A deduction on the basis of arm's length price profit generated out of the order of the Transfer Pricing Officer.

In fact these issues have already been considered in various orders of the Tribunal. The Income-tax Appellate Tribunal, Chennai "A" Bench in the case of Tweezerman (India) P. Ltd. v. Addl. CIT [2010] 4 ITR (Trib) 130 (Chennai) (133 TTJ 308) has considered the matter in detail and held that the reduction of eligible profits of an assessee as done by the Assessing Officer by invoking the provisions of section 80-IA(10) read with section 10B(7), in the context of the Transfer Pricing Officer's order is unsustainable. The Tribunal has held that the Assessing Officer was not justified to invoke the provisions of section 80-IA(10) read with section 10B(7) so as to reduce the eligible profits on the basis of the arm's length price computed by the Transfer Pricing Officer without showing how he determined that the assessee had shown more than "ordinary profits".

As rightly argued by learned senior counsel the arm's length price is determined on the basis of the most appropriate method. The most appropriate method is chosen either on profit basis method or price basis method. In the latter ease, profits are not at all considered. In that method, profit is only a derivative of prices. When profits itself is not worked out, how is it justified to adopt the arm's length price profits to determine what is "ordinary profits" for the purpose of section 10A(7)?

In the facts and circumstances of the case, we hold that the Assessing Officer has erred in reducing Rs.4,48,50,795 from the eligible profits of the assessee under section 10A. The said adjustment made by the assessing authority in computing the deduction under section 10A is accordingly, deleted."

32. In our considered opinion, the result of the Transfer Pricing assessment

can at best be taken as an indicator for the Assessing Officer to investigate as

to whether or not there exists any arrangement which has resulted in more

than ordinary profits qua the requirements of section 10A(7) r.w.s. 80-IA(10) of

the Act. Even if it is accepted that the difference between the operating

margins of the assessee and the comparables show existence of more than

the ordinary profits in the hands of the assessee, so however, it was still 26 ITA No.18/PN/2011

imperative for the Assessing Officer to establish on the basis of substantive

evidence and corroborative material that qua section 10A r.w.s. 80-IA(10) of

the Act, the course of business between the assessee and the associated

enterprises is so arranged that the business transacted between them

produces to the assessee more than the ordinary profits with the intent of

abusing tax concession. Quite clearly, in the entire assessment order, there is

no whisper of any material or evidence in this regard. In-fact, the approach of

the Assessing Officer is quite misdirected as the following discussion in his

order shows :-

"Accordingly, the section only encumbers the A.O. to examine if the profits derived from the eligible business by the assessee is more than the ordinary profits, then the A.O. has to arrive as to what could be the reasonable profit from the such eligible business and such profit has to be then taken as reasonably deemed to have been derived from the eligible business for the purposes of computing deduction under the section."

33. The aforesaid discussion in the assessment order reveals that as per

the Assessing Officer, the existence of close connection and more than

ordinary profits is enough to assume an arrangement as contemplated u/s 80-

IA(10) of the Act. The aforesaid understanding, in our view, is directly contrary

to the judgement of the Hon'ble Karnataka High Court in the case of H.P.

Global Soft Ltd. (supra) and our discussion in the earlier part of this order.

34. In view of the aforesaid, we conclude by holding that in the present

case, the Assessing Officer has not proved that any arrangement had been

arrived between the parties which resulted in higher profits. Consequently, the

re-working of the profits by Assessing Officer by invoking section 10A r.w.s.

80-IA(10) of the Act is not justified. The action of the Assessing Officer to

restrict the deduction u/s 10A of the Act to Rs.7,74,60,281/- as against the

claim of Rs.36,35,09,382/- is hereby set-aside. Thus, assessee succeeds on

this aspect.

27 ITA No.18/PN/2011

35. Now, we may take-up the Ground of Appeal Nos.12 to 17 which relate

to an addition of Rs.22,90,17,412/- made by the Assessing Officer on account

of computation of arm's length price in respect of the international transactions

entered by the assessee with its associated enterprises in respect of System

Integration segment of the assessee.

36. In brief, the relevant facts are that assessee company is a subsidiary of

Honeywell Asia Pacific Inc, USA, which, in turn, is a 100% subsidiary of

Honeywell Inc, USA. The Honeywell group is engaged in diverse areas such

as aerospace, automation and control solutions, specialty material and

transportation and distributions systems. The group performs activities

relating to product/solution development, manufacturing and marketing. The

assessee company, which is a part of Honeywell group, provides industrial

automation and intelligent building control system solutions to industrial

sectors such as petroleum & petrochemicals, chemicals, metals & minerals

and pharmaceuticals. The export division of Honeywell group undertakes

projects across the world.

37. As a part of its business operations, assessee has undertaken varied

transactions with its associated enterprises abroad, which are, namely, (i)

Purchase of raw materials and spares; (ii) Purchase of finished goods for

trading; (iii) Sale of finished goods; (iv) Import of capital goods; (v) Payment of

Royalty; (vi) Receipts for provision of software engineering services for

projects of the Honeywell Group; (vii) Payment of commission for marketing

services; (viii) Payment of technical assistance services received from the

Honeywell Group; (ix) Reimbursement of costs incurred by the affiliates on

behalf of the assessee; and, (x) Recovery of costs incurred by the assessee

on behalf of its affiliates/associated enterprises. The income arising from

international transactions with the associated enterprises is required to be 28 ITA No.18/PN/2011

computed having regard to their arm's length price as mandated by section

92(1) of the Act. In its Transfer Pricing Study, assessee segregated the

international transactions in three heads, namely, Distribution Segment;

Software Engineering Services Segment; and, System Integration Segment.

In order to determine the arm's length price in all the three categories,

assessee adopted the Transactional Net Margin (TNM) Method as the most

appropriate method. As per the Transfer Pricing Study, the assertion of the

assessee was that the entire set of international transactions entered with the

associated enterprises were at an arm's length price and that no adjustment

was required to be made to the stated value of the international transactions.

The Assessing Officer had made a reference to the Transfer Pricing Officer (in

short "TPO") u/s 92CA(1) of the Act for computing of arm's length price in

relation to the international transactions carried out by the assessee with its

associated enterprises. The TPO has passed an order u/s 92CA(3) dated

12.10.2009 determining the arm's length price of the international transactions

entered by the assessee with its associated enterprises. So far as the

segments of Distribution and Software Engineering Services are concerned,

the TPO has accepted that the stated value of the transactions are at an arm's

length price and no adjustment thereon is required. However, he has differed

with the assessee with regard to the System Integration Segment and

therefore, we may confine the discussion with regard to the said dispute,

which is the subject matter of Grounds of Appeal before us.

38. In its System Integration business unit, assessee segregated the

activities into two segments i.e. Manufacturing system segment and

Infrastructure System (IS-Infra) segment. In the Manufacturing system

segment, assessee included Honeywell & Building Control unit's activities

wherein it was providing a spectrum of building services including heating,

ventilation and air conditioning controls, fire, alarm and security systems and 29 ITA No.18/PN/2011

integrated building management systems and Security Solutions unit which

was undertaking designing, engineering and integration of Video Surveillance,

Access Control and Perimeter Intrusions Systems. The manufacturing

systems segment also included some of the activities carried out by the

Industrial Automation Control (IAC) business unit of the assessee. These

activities pertained to the products and services offered to the clients operating

in the process industry. The IAC unit provided services in three areas : (i)

Hardware; (ii) Software and IT solutions to customers; and, (iii) Customer

support services, which included hardware support, software support,

preventive maintenance services, etc..

39. In addition to the aforesaid products and services rendered by the IAC

business unit, it was also executing turnkey projects for the companies

operating in the power sector and this part of the IAC business unit was

categorized as IS-Infra segment. In this manner, the assessee canvassed that

the Manufacturing System segment and the IS-Infra segment, though a part of

the System Integration business unit, were inter se functionally different and

therefore in its Transfer Pricing Study, the two segments were independently

benchmarked while applying the TNM Method.

40. In the Manufacturing System Segment, assessee selected a set of

seven comparables, and the adjusted weighted average operating margin of

the comparables was determined at 6.44% and after comparing it with the

adjusted operating margin of the assessee which came to 7.05%, it was

contended that international transaction pertaining to the Manufacturing

System Segment was at an arm's length price.

41. Now, with respect to the IS-Infra segment, assessee canvassed that the

said segment was functionally different from the Manufacturing Systems 30 ITA No.18/PN/2011

Segment. Therefore, the activities of IS-Infra were analyzed and

benchmarked separately. In the IS-Infra segment, assessee had computed a

loss which was sought to be justified on the basis of various economic and

commercial reasons viz. Technological inefficiency, Operating failures, and

other marketing and administrative failures. The stand of the assessee was

that the said segment of business was not the traditional business of the

Honeywell Group. The functionally different nature of business, the relative

newness of the business of the said segment coupled with the economic and

commercial reasons for the losses, was canvassed to be the key reasons for

which it was considered appropriate to evaluate the IS-Infra segment

separately. On the basis of the above explanation, it was contended that

pricing of the international transactions pertaining to the IS-Infra segment were

consistent with the arm's length price.

42. Another area of difference between assessee and TPO was the

computation assessee's margins in the Manufacturing System Segment. It

was noted that in November, 2004, the 40% shareholding of TATAs in the

assessee company was taken over by the Honeywell Group entities.

Consequent to the acquisition of the TATA Group shareholding by the

Honeywell Group, stringent policies and procedure with respect to the

preparation of financial accounts were formulated which were in accordance

with the policies and procedure adopted across the Honeywell Group. As a

consequence, assessee adopted a more stringent policy for making Provision

of bad debts, liquidated damages and obsolete inventory. On account of the

aforesaid, assessee canvassed that for the financial year ending 31st March,

2006, significantly higher Provisions and write-off of bad debts was made in

the Profit & Loss Account. The assessee contended that it would be

appropriate to consider profits of the Manufacturing Systems segment before

Provision/write-off of bad debts and liquidated damages for the benchmarking 31 ITA No.18/PN/2011

purposes. Accordingly, assessee worked out its adjusted margins of the said

segment. Similarly, the bad debts for all the comparable concerns selected for

the said segment were also not considered while computing their operating

margins. Thus, for the benchmarking purposes assessee compared the mean

of the adjusted operating margins of the comparables with the adjusted

operating margins of its Manufacturing Systems segment.

43. The TPO has differed with the assessee broadly on two counts. Firstly,

the TPO did not accept assessee's approach of segregating the Systems

Integration business unit into two sub-segments i.e. Manufacturing System

segment and IS-Infra segment. The TPO has combined the two sub-

segments under the System Integration segment as a whole for the purposes

of computing the arm's length price of international transactions following the

TNM Method. This is the first area of dispute before us.

44. Another area of dispute is the action of the assessee in adjusting its

operating margins for the Provision and write-off of bad debts/liquidated

damages. On this aspect, the TPO had required the assessee to submit the

operating margins after combining the Manufacturing Systems segment and

IS-Infra segment before and after considering the bad debts adjustment. From

the details furnished by the assessee, the TPO observed that the combined

operating profit to gross sales in respect of the combined System Integration

segment was 3.89% and for the individual segments i.e. IS-Infra and

Manufacturing System segment it stood at (-) 22.86% and 4.69% respectively.

Moreover, the TPO considered the operating margins of the comparable

companies considering their financial data only for the financial year 2005-06

as it pertained to the year under consideration as against assessee's stand in

the Transfer Pricing Study of adopting multiple year's financial data of the

comparable companies. This aspect of the matter is not in dispute before us, 32 ITA No.18/PN/2011

and we do not dwell further on this. Be that as it may, in the combined System

Integration segment, the TPO considered the operating margins of the

comparable companies before and after making adjustments for the bad

debts, which as under :-

"Systems Integration Segment

Sr. Dataflag Name of the Company OP/Sales Adjusted No. (Before bad debts OP/Sales (After adjustment) bad debts adjustment)

1. Prowess Aplab Limited 10.07% 11.13%

2. Prowess Ador Powertron Limited 11.93% 11.93%

3. Prowess Hindustan Dorr-Oliver Ltd. 5.55% 5.55%

4. Prowess Raunaq International Ltd. 6.95% 6.95%

5. Prowess Petron Engineering 9.66% 10.17% Construction Ltd.

6. Prowess Continental Controls Ltd. 2.79% 2.79%

7. C-line Tata Projects Limited N.A. N.A. Average 7.82% 8.09%

N.A. " Not available in the database."

45. From the aforesaid, the TPO inferred that operating margins of four

concerns did not change before and after the bad debts adjustment.

According to the TPO, this indicated that the four concerns did not have any

bad debts at all and therefore there was no change in the ratio of the operating

profits to sales before or after the bad debts adjustment. The TPO noted that

assessee company had indeed incurred bad debts, which have been written-

off, though such amounts were excluded for computing the adjusted operating

profits for the purpose of transfer pricing analysis. According to the TPO, in

such a scenario, the concerns which have incurred bad debts are alone

comparable to the assessee and not those concerns who have not incurred

any bad debts at all. He, therefore, excluded from the final set of comparables

the four concerns which according to him did not incur any bad debts at all,

namely, (i) Ador Power Limited; (ii) Hindustan Dorr-Oliver Ltd.; (iii) Raunaq

International Ltd.; and, (iv) Continental Controls Ltd.. At the same time, the

TPO also disagreed with the assessee on the computation of its operating 33 ITA No.18/PN/2011

margin by adjusting the bad debts adjustment. The TPO considered the

margin of the assessee after deducting the Provision and write-off of bad

debts made and accordingly the operating margin of the assessee for the

System Integration segment as a whole including IS-Infra segment was

determined at 3.89% as against 7.05% considered by the assessee in its

Transfer Pricing Study.

46. Thirdly, with regard to the comparables, the TPO also excluded Tata

Projects Ltd. on the ground that the financial data of the said concern was not

available in the public domain. Therefore, finally the TPO adopted the

following concerns as comparables with Profit Level Indicator (PLI) as

Operating profits/Sales for the System Integration segment as a whole

including IS-Infra segment :-

"Systems Integration Segment :

Sr.No. Dataflag Name of the Company OP/Sales 1. Prowess Aplab Ltd. 10.07% 2. Prowess Petron Engineering Construction Ltd. 9.66% Average 9.87% "

47. In conclusion, the TPO considered the mean operating margin of the

comparables at 9.87 and compared it with the operating margin of the

assessee at 3.89% relating to the System Integration segment as a whole

including IS-Infra. As a consequence, the TPO computed the adjustment of

Rs.22,90,17,412/- that was required to be made to the value of the

international transactions grouped under the System Integration segment

inclusive of IS-Infra segment, in order to bring it to the level of arm's length

price. The concluding para of the order of the TPO reads as under :-

"[22] In view of the facts of the case, deliberation as above the so called two segments of the assessee i.e. Manufacturing Segment and IS-Infra Segment is clubbed together for the purposes of this analysis. Further the PLI adopted is profit over the sales and not the adjusted profit over the sales as submitted by the assessee and the set of comparables is adopted as given in the show 34 ITA No.18/PN/2011

cause notice with the mean operating profit to sales of two comparables at 9.87% against the operating profit margin of the assessee at 3.89%. Considering the above, an adjustment as worked out under is necessary to be made to the total income of the company so that the international transactions grouped under the Systems Integration Segment viz. import of raw material/components; export of finished goods; Import of capital goods; payment of technical assistance services received for projects of the Honeywell Group; payment of commission for marketing services; and payment of royalty to HI for licensed products and parts; are at arm's length:

Gross Sales for the segment = Rs.382,97,22,612/-

The mean operating profit margin of comparables is 9.87%; The operating profit margin of the assessee for the segment is 3.89%; The adjustment required to arrive at the ALP of the transactions grouped under the System Integration Segment is {9.87 - 3.89%} of Rs.382,97,22,612/-;

= 5.98 x Rs.382,97,22,612/-

100 = Rs.22,90,17,412/-

11) As discussed above, an adjustment as worked out Rs.22,90,17,412/-

is necessary to be made to the total income of the company so that the international transactions grouped under the Systems Integration Segment viz. import of raw material/components; export of finished goods; import of capital goods; payment of technical assistance services received for projects of the Honeywell Group; payment of commission for marketing services; and payment of royalty to HI for licensed products and parts; are at arm's length. Consequently this will result in increasing the income of the assessee by this amount."

48. The Assessing Officer has made an addition of Rs.22,90,17,412/- in the

assessment order passed u/s 143(3) r.w.s. 144C(13) of the Act dated

25.11.2010 in conformity with the order of the TPO and after considering the

directions of the DRP dated 29.09.2010. the aforesaid addition is the subject-

matter of dispute before us.

49. Before us, the Ld. Representative for the assessee has assailed the

determination of arm's length price in relation to the System Integration

segment on various grounds. One of the pleas raised is that without prejudice

to the approach of the TPO, the action of the TPO in making adjustment on

the shortfall in the margins of the assessee on total transactions i.e. controlled

as well as uncontrolled was erroneous and instead the adjustment ought to 35 ITA No.18/PN/2011

have been calculated by applying the shortfall in the margin only in relation to

the controlled transactions. In other words, as per the assessee, the

adjustment, if any, was required to be made with respect to the stated value of

the international transactions with the associated enterprises and not on the

total value of the transaction in the System Integration segment which included

transactions with non-related parties also.

50. The Ld. CIT-DR has contested the plea of the assessee by pointing out

that under the TNM Method the profitability of the assessee's System

Integration segment has been compared vis-à-vis the profitability of the

comparables at the segmental level and therefore the shortfall in the margin

was required to be applied to total transactions including those with non-

related parties in order to determine the Transfer Pricing adjustment.

51. On this aspect, in the earlier part of this order, we have reproduced the

conclusion of the TPO as well as the manner in which he has computed the

adjustment of Rs.22,90,17,412/-, which according to him is required to be

made to the international transactions of System Integration segment of the

assessee in order to be bring it to the level of arm's length price. Pertinently,

the mean operating profit of the comparables was deduced at 9.87% and the

operating margin of the assessee's System Integration segment was adopted

at 3.89%. The shortfall between the mean operating margin of the

comparables and the profit margin of the assessee's System Integration

segment was applied to the gross sales of the assessee in the System

Integration segment amounting to Rs.3,82,97,22,612/-. Accordingly, the

adjustment has been worked. It is undeniable that so far as the gross sales of

Rs.3,82,97,22,612/- is concerned, it is inclusive of the transactions with

associated enterprises as well as with non-related parties. The exercise of

Transfer Pricing assessment is undertaken to determine the income from the 36 ITA No.18/PN/2011

international transactions entered by the assessee with associated enterprises

having regard to their arm's length price. The objective of adopting the most

appropriate method, which in the present case is TNM Method, is to determine

the arm's length price of the international transactions. Therefore, the

adjustment, if any that is required to be made as a consequence of the

application of the most appropriate method is to be made with respect to the

value of the international transactions entered with associated enterprises

alone. On this aspect, the Ld. Representative for the assessee has relied

upon the decisions of the Mumbai Bench of the Tribunal in the case of

Thyssen Krupp Industries vs. ACIT vide ITA No.7032/Mum/2011 dated

27.11.2012 as well as in the case of Hindustan Unilever Ltd. vs. Addl.CIT vide

ITA No.7868/Mum/2010 dated 10.12.2012, copies of which have been placed

on record. In terms of the aforesaid precedents, it is to be held that the

adjustment which is made by the TPO on the entire turnover of the System

Integration segment of the assessee is erroneous and that it should be

restricted to the international transactions entered with associated enterprises

alone.

52. At the time of hearing, the Ld. Representative pointed out that the value

of transactions with associated enterprises is only Rs.67,25,00,000/- as

against the transactions with non-related parties of Rs.30,82,00,000/-

comprised in the transactions considered by the TPO. On this aspect, we

uphold the plea of the assessee that the determination of the Transfer Pricing

adjustment, if any, should be restricted to the value of the international

transactions carried out by the assessee with its associated enterprises.

Thus, on this aspect, assessee succeeds.

53. Another aspect which has been argued before us is with regard to the

exclusion of Hindustan Dorr-Oliver Ltd. from the final set of comparables. On 37 ITA No.18/PN/2011

this aspect, we find that in terms of the discussion in the para 3.4.2 of the

show-cause notice dated 18.06.2009 issued by the TPO, the said concern has

been excluded on the ground that it has not incurred any bad debts. As noted

by us earlier, the TPO has observed that operating margins of certain

companies did not change before and after the bad debts adjustments, which

indicated that such concerns did not have any bad debts at all. Since

assessee had incurred bad debts, the TPO considered only those concerns as

comparables who had incurred bad debts and thereby excluded such

concerns from the list of comparables which did not have any bad debts at all.

Hindustan Dorr-Oliver Ltd. was excluded from the list of comparables by the

TPO on this count.

54. Though the Ld. Representative for the assessee contended that the

action of the TPO was unjustified in-principle, so however, it is pointed out that

by applying the filter adopted by the TPO himself, the said concern could not

have been excluded from the list of comparables as it had incurred bad debts

related expenditure. In this context, the Ld. Representative for the assessee

furnished Annual Reports of the said concern for the financial years ending

31.03.2004 and 31.03.2007 which indicated that the said concern has indeed

accounted for the bad debts. It is pointed out that the said concern has over

the years incurred bad debts and therefore on the basis of the said filter, it

could not be excluded from the final set of comparables. The Ld. CIT-DR has

reiterated the stand of the TPO, which we have already noted above in the

earlier paras.

55. At the outset, one may notice that incurrence of bad debts in the

course of carrying on business is a generally accepted incident of business.

The bad debts incurred in the course of carrying on of business is a

commercial loss which is indeed permissible as a deduction while computing 38 ITA No.18/PN/2011

the profits, subject of-course to the prescribed conditions under the statute.

Nevertheless, de hors the provisions of the Act, in common parlance also bad

debt is understood as a charge against the profits of the business. So

however, the vagaries of the business are such that it may be possible that in

a particular year a concern may not incur bad debts at all or it may also

happen that in a particular year, certain extraordinary bad debts are incurred

by a concern. Be that as it may, without going into merits of the filter setup by

the TPO to exclude those concerns who have not incurred any bad debts at

all, in the context of Hindustan Dorr-Oliver Ltd., we find that assessee has

justifiably pointed out that the incident of bad debts, liquidated expenses is

present. Therefore, in our view, the said concern has been inadvertently

excluded from the final set of comparables, even if one goes with the filter

applied by the TPO. We say that it is inadvertently excluded for the reason

that apart from the reference in the show-cause notice, which we have stated

above, in the entire order of the TPO there is no reason ascribed for excluding

the said concern from the final set of comparables. Therefore, having regard

to the aforesaid discussion, we direct the Assessing Officer/TPO to include the

said concern in the final set of comparables.

56. At the time of hearing, it was submitted by the Ld. Representative for

the assessee that without going into the action of the TPO in aggregating the

sub-segments of Manufacturing System segment and IS-Infra segment for the

purposes of comparability analysis, if the adjustment is restricted to the

transactions with associated enterprises alone and Hindustan Dorr-Oliver Ltd.

is included as a comparable in the final set of comparables and also without

making adjustment for the bad debts, etc. the value of international

transactions of the assessee falls within +/- 5% range of the mean operating

margins of the comparables, and therefore in terms of section 92C(2) of the

Act no adjustment would be required to be made to the stated value of the 39 ITA No.18/PN/2011

international transactions with associated enterprises. Since the appellant has

succeeded on the aspect of restricting the adjustment to the international

transactions alone and also on the inclusion of Hindustan Dorr-Oliver Ltd. as a

comparable, the other Grounds of Appeal on the aspect of the Transfer Pricing

adjustment are rendered academic and are not being adjudicated for the

present. Thus, on the Ground of Appeal Nos.12 to 17 assessee partly

succeeds.

57. The Ground of Appeal No.11 is relating to disallowance of Provision for

expenses amounting to Rs.1,72,00,000/-, which has not been pressed at the

time of hearing and is accordingly dismissed.

58. In the result, the appeal of the assessee is partly allowed.

Order pronounced on 25 th February, 2015.

Sd/- Sd/- (R.S. PADVEKAR) (G.S. PANNU) JUDICIAL MEMBER ACCOUNTANT MEMBER

Pune, Dated: 25 th February, 2015. Sujeet

Copy of the order is forwarded to: - 1) The Assessee; 2) The Department; 3) The DRP, Pune; 4) The DIT (International Taxation), Pune; 5) The DR "B" Bench, I.T.A.T., Pune; 6) Guard File.

By Order //True Copy//

Assistant Registrar I.T.A.T., Pune