High Court upheld inclusion and exclusion of comparables by TPO based on filters adopted

High Court upheld inclusion and exclusion of comparables by TPO based on filters of losses, declining sales, segment reporting employee cost etc.

ABCAUS Case Law Citation:
ABCAUS 2280 (2018) (04) HC

The appellant assessee had filed the instant appeal under Section 260A of the Income Tax Act, 1961 (Act), impugning the judgment of the Income Tax Appellate Tribunal (ITAT) in rejecting comparables selected by the appellant and approving fresh comparables as added by the TPO for the purpose of determination of arm’s length price.

inclusion and exclusion of comparables by TPO

The appellant was a subsidiary of a UK based company which was an associated enterprise (AE) of the appellant under section 92A of the Act. The appellant was engaged in providing software and BPO services to its AE.

For the relevant financial year, the appellant reported international transaction of provision of software services. The appellant selected Transactional New Margin Method (TNMM) as the most appropriate method for benchmarking the international transaction under the software development services segment.

However, the Transfer Pricing Officer (TPO) passed an order u/s 92CA(3) of the Act, inter alia, recommending upward transfer pricing adjustment to the software development services segment of the appellant. The TPO rejected some comparables selected by the appellant and added fresh comparables, thereby selecting 16 final comparables for benchmarking the international transaction.

Subsequently, the Dispute Resolution Panel (DRP) passed an order under Section 144C (5) of the Act, inter-alia, excluding three companies from the final set of comparables drawn by the TPO. Again, DRP passed rectification order excluding one comparable. The order was further rectified.

Aggrieved by the final order as well as rectification orders, the appellant approached the Tribunal. The Tribunal vide the impugned order, partly allowed the appeal. However, ruled against the appellant upholding the inclusion and exclusion of one company and exclusion of two companies as comparables for benchmarking the international transaction under the software development services segment.

The Hon’ble High Court noted that the TPO had observed that inappropriate filters had been used by the Petitioner which would lead to an incorrect choice of comparables. The findings of the TPO with respect to filters were under:

No. Description of filter Remarks of this office
1. Reject companies that have insufficient financials or descriptive information to perform analysis This is an appropriate filter. However, the data is to be seen with reference to current financial year i.e. FY 2009-10.

Reject companies that had been declared sick or had persistent negative net worth

This is an appropriate filter. However, the correct criteria for rejection of companies would be negative net worth and not persistent negative net worth as the company having negative net worth would also be incurring losses in the past so as to erode its positive net worth which is the norm for companies in IT industry as discussed later

3. Reject companies that had ceased Business operations/ no sales. The filter is insufficient. The correct filter would be to exclude companies having sales less than 5 Cr. as it will eliminate start-up companies and also companies where there is little differentiation between profits and remuneration

Reject companies Undertaking significantly different functions compared to assessee

The filter is an appropriate filter. However, the same has not been correctly applied as the functions of comparables have not been correctly analyzed in the TP report as discussed later


Reject companies that have significant (less than 25%) foreign exchange earnings

The rationale for the filter is appropriate. However, since the assessee company is having 100% of its income from exports to its AEs, the limit of 25% is inadequate and the filter is required to be applied with the thresh hold of 75%.


Reject companies that have substantial (excess of 25%) related party transactions.

This is an appropriate filter.


Reject companies incurring Persistent operating losses.

This is an appropriate filter. However, only companies which are incurring losses persistently are to be rejected as against companies which have made loss once in a while. This is an appropriate filter because of the reason that software industry has been growing at a rate of more than 20% and in such an environment, a company making persistent losses does not reflect the industry conditions and is in persistent losses because of company specific issues

8. Reject companies that had exceptional year of operation. The reasons for exceptional year need to be analysed. The company can be rejected or data may be modified to exclude the income attributable to factors other than operations.

Reject companies that were duplicated in the databases with different names or merged to form another company.

If the filter is meant to exclude only the duplicate company, the same is an appropriate filter. Otherwise it is not an appropriate filter as it will exclude a company for extraneous reason like change in name, merger etc. which do not have impact on the operational performance.

Further the Hon’ble High Court observed that the TPO had found the following set of filters to be appropriate keeping in mind the profile of the company, and justified the same as under:

Use of current year data The transfer pricing provisions lay down that primarily current year data should be use. The proviso to Rule 10D(4) allows the use of multiple year data only if the assessee is able to demonstrate through relevant data that certain factors of earlier years has affected the transfer prices for the current year. There are sufficient judicial pronouncements that support the use of current year data.
Different financial year If a company is having an accounting year different from financial year for which financials of your company are being considered, the same has been excluded as the profits and revenue pertain to different period other than current year.
Reject companies where turnover is less than Rs. 5 Crore This filter is applied as it will eliminate start-up companies and also companies where there is little differentiation between profits and remuneration. That apart, a company that is very small in size and the cost base is very small does not have sufficient economic significance that it be used for benchmarking

Select companies where the ratio of service income to total income is at least 75%

The use of this filter is to ensure that we choose companies that are primarily in the service sector. This filter ensures that companies that have significant incomes from manufacturing and trading activities are rejected. In your case your entire income is from provision of services and thus, the threshold for applying this filter has been taken at 75%. It would not be appropriate to benchmark your case against a company that has significant income from manufacturing or trading activities. This filter will thus ensure integrity of all comparable data.

Reject companies where related party transactions exceed 25% of sales

There is no doubt that companies with significant related party transactions need to be excluded from the benchmarking process. On the issue of threshold of related party transactions, it can be stated that when the RPT exceeds 25% of sales, it can be said to be the stage when it will start affecting the price paid/received. The rationale given for the use of the limit of 25% is sound and this threshold limit has been approved explicitly an implicitly in quite a few judicial pronouncements.

Companies that have employee cost that is less than 25% of total cost

The rationale for this filter is that companies that are engaged in providing services similar to yours will require a minimum level of expenditure as personnel expense. Employees cost constitutes the major component of cost in any service sector. Very low employee cost, viz., less than 25% of total cost, indicates that company is either engaged in some other business or it has outsourced the service functions to a third party, i.e., it is not rendering services on its own. Such companies cannot be treated as functionally comparable to the assessee.

Companies that are affected by some peculiar economic circumstances

Companies that are affected by factors like persistent losses, declining sales, extraordinary income or expense, mergers and acquisitions or other such factors which affect the operations of the company substantially should not be used as comparables as they will not prove to be good benchmarks.

With regard to the comparable added, the TPO held that the said comparable was available in Capitaline database and cleared all the requisite filters as above.

With regard to objection of the petitioner qua inclusion of one of the comparable, it was observed that the TPO had taken only the ‘Overseas’ segment for the purposes of inclusion in the list of comparables, which encompassed only export of software services. The Hon’ble High Court opined that the segment taken by the TPO fully matched and was held to be comparable by the ITAT which were findings of facts based upon record. Consequently, taking it as a comparable was in order and cannot be interfered with.

With respect to the exclusion made, the Hon’ble High Court found that the TPO had found that said company did not qualify the employee cost filter. It was making persistent losses in software services segment. Apart from earning income from Software services, said company also earned income from ‘Business process outsourcing services’, which fell in the realm of I.T. enabled services. TPO found that there was no segmental information qua the software services alone. Consequently, its exclusion was in order and cannot be interfered with.

With respect to the another exclusion made, the Hon’ble High Court observed that factually, the said company was an abnormal company; as on one hand, sales were declining, receivables and write-offs were increasing. Debtors of earlier years were affecting the working capital adjusted OP/TC of the company significantly. Said company was regularly incurring losses. Persistent losses coupled with declining turnover over the period indicated abnormal functional circumstances, which rendered it non-comparable and justified the exclusion of such a company from the list of comparables. Consequently, its exclusion was in order and cannot be interfered with.

The appeal was dismissed as not giving rise to any substantial question of law.

inclusion and exclusion of comparables by TPO

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