Introduction
This case commentary analyzes the decision of the Income Tax Appellate Tribunal (ITAT), Delhi Bench, in Aircom International (India) Pvt. Ltd. vs. DCIT (ITA No.5743/Del/2011, Assessment Year 2007-08). The ruling addresses critical issues in transfer pricing, depreciation classification, and expenditure characterization under the Income-tax Act, 1961. The Tribunal’s order, pronounced on 27 July 2017, provides significant guidance on the exclusion of comparables in transfer pricing analysis, the eligibility of computer peripherals for higher depreciation, and the treatment of license fees as revenue expenditure. This commentary focuses on the legal reasoning behind the Tribunal’s decisions, emphasizing the principles of comparability, functional analysis, and the arm’s length price (ALP) determination.
Facts of the Case
The assessee, Aircom International (India) Pvt. Ltd., a 100% subsidiary of Aircom International Ltd., UK, was engaged in providing software solutions and consultancy services to the telecommunication industry. For the Assessment Year 2007-08, the assessee reported international transactions in three segments: Software Development, Software Deployment/Training/Consultancy/Equipment Rental, and Support Services. The Transfer Pricing Officer (TPO) applied the Transactional Net Margin Method (TNMM) with the Profit Level Indicator (PLI) of Operating Profit to Total Cost (OP/TC) for the Software Development Services segment. The TPO selected five comparable companies, later reduced to four by the Dispute Resolution Panel (DRP), resulting in a transfer pricing adjustment of Rs. 25,05,480/-. The assessee challenged the inclusion of two comparables—Kals Information Systems Ltd. (Seg.) and Sasken Communication Technologies Ltd. (Seg.)—before the ITAT. Additionally, the assessee contested the disallowance of depreciation on printers, scanners, and NT servers at 60%, and the treatment of license fees paid to the Associated Enterprise (AE) as capital expenditure.
Reasoning of the Tribunal
The Tribunal’s reasoning is structured around three core issues: transfer pricing comparability, depreciation classification, and expenditure characterization. Each is analyzed in detail below.
Transfer Pricing Comparability: Exclusion of Kals and Sasken
The Tribunal first addressed the Revenue’s preliminary objection that the assessee could not seek exclusion of comparables it had originally selected. The Tribunal rejected this argument, citing the principle that there is no estoppel against the statute. It relied on the Special Bench decision in DCIT vs. Quark Systems Pvt. Ltd. (2010) 132 TTJ (Chd) (SB) 1 and the Delhi High Court ruling in Xchanging Technology Services India Pvt Ltd [TS-446-HC-2016(DEL)-TP], which held that a company wrongly included as a comparable can be excluded if proven incomparable. The Tribunal emphasized that the object of transfer pricing is to determine the correct ALP, and the assessee is not barred from correcting errors in its initial selection.
Kals Information Systems Ltd. (Seg.): The assessee argued that Kals was primarily a software product company, not a pure software development service provider. The TPO had included Kals based on its response to a notice under Section 133(6), which stated that software development services constituted over 88% of its revenue, with training contributing 0.7% to 8.56%. However, the Tribunal noted that the assessee’s segment did not include any training revenue. The presence of training revenue in Kals’ operations, even if small, created a functional difference. The Tribunal held that comparability requires similarity in functions, assets, and risks. Since Kals derived revenue from training—an activity absent in the assessee’s software development segment—it was not functionally comparable. The Tribunal excluded Kals, reinforcing the principle that even minor functional differences can disqualify a comparable.
Sasken Communication Technologies Ltd. (Seg.): The assessee contended that Sasken’s financials were distorted due to mergers and acquisitions during the relevant year. The Tribunal accepted this argument, noting that extraordinary events like mergers can significantly impact profitability ratios, making the company’s data unreliable for benchmarking. The Tribunal held that comparables must reflect normal business operations without distortions. Since Sasken’s financials were not representative of a routine software development service provider, it was excluded.
The Tribunal’s reasoning underscores the importance of functional analysis and data integrity in transfer pricing. It rejected the TPO’s mechanical inclusion of companies based solely on revenue thresholds, emphasizing that comparability must be assessed holistically.
Depreciation on Printers, Scanners, and NT Servers
The assessee claimed depreciation at 60% on printers, scanners, and NT servers, treating them as computer peripherals. The AO had allowed only 15% depreciation, classifying them as general office equipment. The Tribunal applied the ‘no stand-alone application’ test, which examines whether the asset can function independently without a computer. It held that printers, scanners, and NT servers are integral to computer systems and cannot operate without a computer. Therefore, they qualify as computer peripherals eligible for 60% depreciation under the Income-tax Rules, 1962. The Tribunal’s reasoning aligns with the principle that depreciation rates should reflect the asset’s technological obsolescence and functional dependency.
License Fees as Revenue Expenditure
The assessee paid license fees to its AE for using software products. The AO treated this as capital expenditure, arguing that it created an intangible asset. The Tribunal disagreed, characterizing the payments as cost of goods sold. It held that the license fees were incurred for the use of software in the assessee’s business operations, not for acquiring ownership or enduring benefit. Since the assessee did not obtain any capital asset, the expenditure was revenue in nature. The Tribunal deleted the addition, reinforcing the principle that payments for the right to use software, without transfer of ownership, are allowable as revenue expenditure.
Conclusion
The ITAT’s decision in Aircom International provides clarity on several contentious issues in transfer pricing and tax law. By excluding Kals and Sasken from the comparable set, the Tribunal reinforced the need for rigorous functional analysis and data reliability. The ruling on depreciation aligns with technological realities, recognizing printers, scanners, and NT servers as computer peripherals. The treatment of license fees as revenue expenditure reflects a pragmatic approach to software licensing. This case serves as a valuable precedent for taxpayers and tax authorities, emphasizing that transfer pricing adjustments must be based on accurate comparables and that depreciation and expenditure classifications must follow functional and economic substance.