P.V.S.S. Prasad for the Appellant. 
Solgy Jose T. Kottaram for the Respondent.

The order of the Bench was delivered by

B. Ramakotaiah, Accountant Member - This appeal by assessee for A.Y. 2007-08 is against the order of the A.O. under section 143(3) read with section 92CA and 144C of the Income Tax Act, 1961 passed consequent to the directions given by the DRP, Hyderabad dated 26.08.2011.

2. The issue in this appeal is with reference to addition made by the A.O./TPO under the T.P. provisions of the Income Tax Act on the international transactions for software development services provided to its AE to an extent of Rs.2,18,08,428/-. In the present appeal, even though assessee raised 8 grounds, ground No.2 pertaining to rejection of comparables selected by assessee company and allowance of 5% variation from the mean as a standard deduction raised in ground No.7 are not pressed. Ground Nos.1 and 8 are general in nature and therefore, they need not be adjudicated.
3. Ground Nos.3 to 6 are as under :

"3. The Ld. AO/TPO erred in selecting functionally dissimilar companies as comparables for bench marking analysis, not justified in adopting the high arithmetic mean and working capital adjustment at the rate of 27.67% (24.35% + 3.32%).
4. The Ld. AO/TPO ought to have accepted and excluded Rs.5.66 crores from the cost base for calculating profit margin of the assessee company for bench marking analysis.

5. The Ld. AO is erroneous in law in not adjusting the losses against the income assessed.

6. The Ld. AO/TPO legally erred in applying the Profit Level Indicator (PLI) on the total operating cost instead of applying PLI on cost relating to international transactions entered with Associated Enterprises (AE)".

4. The above four grounds are with reference to adjustment made under the T.P. provisions.

4.1. Briefly stated, assessee AxSys Healthtech Ltd. (Axsys), is a company incorporated under Indian Companies Act situated at Hyderabad is in the business of developing Healthcare related software products and has a full-fledged development centre. It has an AE by name AxSys Technology Ltd(ATL) based in Glasgow, Scotland, U.K. which was setup to exploit potential of developing and marketing leading edge patient-centered, clinical information systems for use in healthcare industry. Since its incorporation Axsys has concentrated in the development of core architect that can be used as a basis for providing wide ranging patient centered solutions to the healthcare market. The main Axsys product Excelicare incorporates advanced telecommunication technologies within a clinician friendly electronic patient record. Excelicare is an enterprise wide solution that addresses the complete spectrum of healthcare from management of patients at Home, through primary Care to acute tertiary-care hospitals. During the relevant period, the company had international transactions by way of sale of software to its AE to an extent of Rs.2.18 crores. In its T.P. report, assessee selected itself as a tested party and after analyzing various methods, the most appropriate method selected was TNMM. The assessee has selected some (5) comparables and arrived at average PLI (OP/Operating Cost) at (-) 10% and assessee PLI (OP/OC) at (-) 71% (sic) and therefore, considered it as arms length which meets the law.

5. However, the TPO rejected the assessee's comparables and undertook fresh comparables and selected 26 comparables whose arithmetic mean PLI was arrived at 25.14%. He made negative working capital adjustment of (-) 3.32% and determined the ultimate arithmetic mean PLI at 28.46%. Taking the operating cost (excluding R & D expenditure written off and extraordinary item) at Rs.7,55,48,211/-, arrived at the ALP value of services provided at Rs.9,70,49,232/-. Since the assessee's price charged in the international transaction was only Rs.2,18,08,428/- the short fall of Rs.7,52,40,804/- was treated as T.P. adjustment under section 92CA of the Act.

6. Assessee raised objections before the DRP on various issues including rejection of assessee's 5 comparables and determining operating cost at Rs.7.55 crores as against Rs.1.89 crores of the assessee and also objected on the comparables both on functional analysis and also other reasons of extraordinary events etc., The DRP, however, except excluding two comparables did not accept the other objections of the assessee. Hence, assessee is in appeal before us.

7. Ld. Counsel summarized the issues and submitted that assessee is objecting to taking the operating cost at Rs.7.55 crores as against Rs.1.89 crores arrived by it and referred to the objections before the DRP which were not considered.

8. It was submitted that assessee is objecting to selection of comparables by the TPO and mainly about 14 comparables which are already rejected by ITAT in various orders as not comparable on valid reasons.

9. The next issue as stated is with reference to negative working capital adjustment made. It was submitted that even otherwise if the operating cost and comparables are correctly selected, then the average of balance of comparables would be within the limits as prescribed in the Act and no adjustment is required on the facts of the case.

10. Learned D.R. however, objected to various issues. The detailed contentions of the respective parties are discussed in the course of this order.

11. We have considered the rival contentions and examined the facts on record. The issues in this appeal can be classified under two heads 'operating cost' and 'selection of comparables', for the sake of discussion.

11.1 Operating cost: With reference to determination of operating cost, assessee has spent a total amount of Rs.10,72,46,059/- as expenditure during the year on a total receipts of Rs.2,77,97,662/-. Out of this, R & D expenditure written off pertaining to earlier years was of Rs.2,74,97,491/-and extraordinary item of Rs.42,00,357/- were excluded by the TPO himself. Therefore, there is no dispute with reference to above amounts between Assessee and Revenue. The above R & D expenditure was claimed as 1/5th deferred revenue expenditure having been incurred in financial years 1999-2000 to 2001-02. The total amount of Rs.10,98,25,000/- was claimed over a period of 5 years at Rs.2,11,65,000/- from FY 2002-03 to FY 2006-07. Therefore, the amount of Rs.2,19,65,000/- was the final and 5th year amount claimed in the P & L account this year. In addition, assessee also incurred an amount of Rs.2,76,62,453/- in development of software analysis systems and products which were shown under the head "Research & Development" expenditure. This amount also was claimed as deferred revenue expenditure over a period of 5 years commencing from F.Y. 2004-05 to F.Y. 2008-09 at Rs.55,32,491/-. Thus, in this year total amount of Rs.2,74,97,491/- was debited to P & L account. As noticed from the orders in earlier years, the A.O. excluded this amount from the computation of income as well as from computation of operational cost in the preceding assessment year and assessee even though objected before the DRP, withdrew the claim, as by excluding this amount from operational cost assessee's arithmetic mean of PLI was above the comparables in that year. The DRP vide its order dated 30.09.2010 for A.Y. 2006-07 accepted the assessee's contentions and directed the TPO to exclude the amount from computation of operational cost. Keeping that in mind, the TPO himself has excluded the amount in this year. The dispute is not with reference to the above amount but an amount of Rs.5.66 crores stated to have been spent towards R & D expenditure out of Rs.7.55 crores taken as operating cost by the TPO. It was the contention that the assessee has spent this amount for developing of future products/existing products. Therefore, for the same reason of excluding the expenditure incurred in earlier years, this amount should not be considered as operating cost as the assessee has not earned any amount as products are still in development stage. TPO/A.O. did not comment about this claim but observed vide page-4 of T.P. order at para 2.3 stating that no evidence was furnished in respect of the costs that are excluded. DRP also inspite of specific objection by the assessee neither commented about the nature of expenditure nor given any directions either to verify to exclude or include.

11.2 Before us, Ld. Counsel submission was that this amount was spent for developing new products and he placed on record the agreement dated 15.09.2004 between the assessee company and its AE and also filed a chart indicating the allocation of 'percentage of man-hours' used for new product development. He has placed a chart bifurcating the amount of Rs.7,55,48,212/- into Rs.56,58,56,111/- towards proportionate amount towards R & D and cost of others R & D at Rs.1,89,62,201/-.

11.3 Even though these two statements were furnished, we are unable to give any finding on this issue as neither TPO nor DRP examined the said expenditure. For that one has to understand nature of development of new products by the assessee and its capitalisation of expenditure as such. Assessee incurred expenditure as a 'start-up' expenditure in the nature of software development between FY 1999-2000 to 2001-2002 and that expenditure was claimed as deferred revenue expenditure in each of the 5 years. In the books of account this expenditure was shown under the head "Research and Development" expenditure as 'intangible assets' in the fixed assets in order to confirm to the account policy followed by its subsidiary in U.K. If the amount pertains to development of a product, the same would automatically become cost of the product on which, proportionate write-off or depreciation was allowable which would be part of operating cost, like depreciation for use of assets. However, for the reasons best known to the assessee and the DRP, the expenditure claimed as 'deferred revenue expenditure' was excluded from the operating cost. Difficulty in this year is with reference to claim of Rs.5.65 crores claimed in the P & L account. The expenditure stated to have been incurred for development of new product was not categorised as 'Research and Development' expenditure in the P & L account or in the Balance sheet. It was shown/claimed as part of 'administrative and other expenses'. Moreover, even the charts furnished before us indicate only 'proportionate allocation' of expenditure rather than actual expenditure incurred on R & D. The basis for proportionate allocation was also not placed before us. But it was stated to be man-hours spent. Even otherwise as seen from the agreement, assessee has undertaken to engage in software development and customization for AE. Therefore, the cost of development of new product seems to be not on the assessee but on the AE. However, these contentions were neither examined nor commented upon by either of the revenue authorities. Therefore, in the absence of any clarity on the issue, we cannot give a finding either to exclude the amount or include the amount as part of operating cost.

Considering the fact that Revenue itself has excluded the earlier R & D expenditure from the computation of operating cost, assessee's contention seems to be genuine, if such expenditure was R & D for development of future products. Therefore, without going into the merits of the contentions, we are of the opinion that this issue require examination by the TPO/AO afresh about the nature of expenditure incurred and why the amount was not categorised as R & D expenditure and whether any product was developed to which this expenditure was capitalized or claimed 'as relating to' in later years. Those years P & L account, Balance sheets are not before us and we are not made aware about such claims/accounting treatment in later years. In view of this, the issue of 'operating cost' is set aside to the file of the TPO/A.O. for fresh examination of the assessee's contentions for determining the operating cost.

12. Selection of Comparables: The next issue for consideration is with reference to comparables. As briefly stated above, out of 26 comparables selected by the TPO, DRP excluded 2 comparables vide its order in page No.17. A.O/TPO was directed to exclude two concerns i.e., 1. Celestial Labs Ltd., and 2. Geometric Ltd., from the list of comparables and to re-compute the margin. However, A.O. vide his order dated 30.12.2010 ignored the directions of the DRP and made addition of same amount of Rs.7,52,40,804/- proposed by the TPO in the draft assessment order. To that extent, order of the A.O. is not consistent with the directions of the DRP. A.O. is directed to exclude the above 2 comparables. There is no need to discuss about these 2 comparables by us as these are already excluded by the DRP. Therefore, to the extent of these 2 comparables, we direct the A.O/TPO to exclude the comparables as per the directions of the DRP.

12.1 Assessee placed a chart accepting 10 comparables, which areas under.

12.2 Assessee is objecting to the following 14 comparables

13. In all the cases above, Ld. Counsel relied mainly on the Coordinate Bench decision in the case of Trilogy E-Business Software India (P.) Ltd v. Dy. CIT [2013] 140 ITD 540/29 taxmann.com 310 (Bang.) for exclusion of the comparables, except one in case of Helios & Matheson which was objected relying on the Coordiante Bench decision in the case of Avineon India (P.) Ltd. v. Dy. CIT [2014] 41 taxmann.com 334 (Hyd.).

14. After hearing rival contentions, we agree that the following comparables were excluded by the Coordinate Benches considering the similar facts and arguments raised before us:

1. functionally dissimilar.
1. Accel Transmatic Ltd.—
"On careful perusal of the business activities of Accel Transmatic Ltd. DRP agreed with the assessee that the company was functionally different from the assessee company as it was engaged in the services in the form of ACCEL IT and ACCEL animation services for 2D and 3D animation and therefore assessee's claim that this company was functionally different was accepted. DRP therefore directed the Assessing Officer to exclude ACCEL Transmatic Ltd. from the final list of comparables for the purpose of determining TNMM margin."

2. Avani Cincom Technologies Ltd.

"Here in this case also the segmental details of operating income of IT services and sale of software products have not been provided so as to see whether the profit ratio of this company can be taken into consideration for comparing the case that of assessee. In absence of any kind of details provided by the TPO, we are unable to persuade ourselves to include it as comparable party. Learned CIT DR has provided a copy of profit loss account which shows that mainly its earning is from software exports, however, the details of percentage of export of products or services have not been given. We, therefore, reject this company also from taking into consideration for comparability analysis."

3. KALS INFORMATION SYSTEMS LTD:
"We have given a careful consideration to the submission made on behalf of the Assessee. We find that the TPO has drawn conclusions on the basis of information obtained by issue of notice u/s.133(6) of the Act. This information which was not available in public domain could not have been used by the TPO, when the same is contrary to the annual report of this company as highlighted by the Assessee in its letter dated 21.6.2010 to the TPO. We also find that in the decision referred to by the learned counsel for the Assessee, the Mumbai Bench of ITAT has held that this company was developing software products and not purely or mainly software development service provider. We therefore accept the plea of the Assessee that this company is not comparable".

4. LUCID SOFTWARE LIMITED:
"The objections raised by the assessee for inclusion of Lucid Software Ltd. as a comparable is placed at pages 244 to 248 of the paper book filed by the assessee. We find identical objection has been raised against the inclusion of Lucid Software in case of Telcordia Technologies. Since the facts and the assessment year are identical, following the order of the Tribunal in the case of Telcordia Technologies Pvt. Ltd. v. ACIT (supra), we direct the Assessing Officer/TPO not to include Lucid Software Limited as a comparable."

2.employee cost filter:
5. ISHIR INFOTECH LTD:

"So far as this company is concerned, the assessee has sought exclusion of the aforesaid company on the ground that this company fails employee cost filter as its employee cost was only 3.96%. In this context, the learned AR has relied upon the decision of co-ordinate Bench of this Tribunal in case of M/s Virtusa (India) Pvt. Ltd. (supra). On a perusal of the order passed in case of M/s Virtusa (India) Pvt. Ltd.((supra)), we find that the co-ordinate bench has held that Ishir Infotech Limited cannot be treated as comparable as it does not qualify the employee cost filter as well as RPT filter. This view of ours is also in tune with the view expressed by different Benches of this Tribunal as stated below :

3. High Turnover- functionally dissimilar:

6. FLEXITRONICS SOFTWARE LIMITED :

As far as Flexitronics Software Limited is concerned, we find that at page 90 of his Order, the TPO has also observed that the said company has incurred expenditure for selling of products and has incurred R & D expenditure for development of the products. The above facts clearly demonstrate that there is functional dissimilarity between the assessee and these companies and without making adjustment for the dissimilarities brought out by the TPO himself, these companies cannot be taken as comparable companies. The method adopted by the TPO to allocate expenditure proportionately to the software development services and software product activity cannot be said to be correct and reasonable. Wherever, the Assessing Officer/TPO cannot make suitable adjustment to the financial results of the comparable companies with the assessee-company to bring them on par with the assessee, these companies are to be excluded from the list of comparables. Therefore, we direct the Assessing Officer/TPO to exclude from the list of comparables."

7. INFOSYS TECHNOLOGIES Ltd.:

"We have heard both the parties. We find that Infosys Technologies Ltd., though, is into the similar business of the assessee as software development, cannot be considered as a comparable to any other companies which are also involved in similar activities. It is not only a giant company but is also engaged in development of various niche products. It cannot be compared to the assessee in any manner. Similar directions have been given by the Tribunal at Delhi and Hyderabad Benches in the cases cited (supra)".

8. TATA ELXSI LIMITED :

"As regards this company, the learned Counsel appearing on behalf of the assessee, filed before us the reply of Tata Elxsi Limited to the Addl. CIT (Transfer Pricing), Hyderabad, wherein the concerned Officer has been informed that Tata Elxsi Limited is specialised Embedded Software Development Service Provider and that it cannot be compared with any other software development company. It was submitted that because of the specialisation and also becauseof diverse nature of its business, it is very difficult to scale-up the operations of Tata Elxsi Limited. In view of this, Tata Elxsi Limited has informed that it is not fair to use its financial numbers to compare it with any other company. The communication dated 25th August, 2009 to the TPO is placed before us. As this communication was not before the TPO at the time of transfer pricing adjustment we deem it fit and proper to remand this issue also to the file of the TPO to reconsider adopting this company as the comparable in the light of observations of this company to the TPO in the case of another assessee. In the result, the Assessing Officer/TPO is directed to reconsider the issue in accordance with law, after affording a reasonable opportunity of being heard to the assessee".

9. WIPRO LIMITED :

" .As far as (Infosys Technologies Limited and) Wipro Limited are concerned, we find that both are giant companies and are into diversified activities and for the detailed reasons given by us in assessee's own case for the A.Y. 2005-06 even dated, we direct that these two companies are to be excluded from the list of comparables."

14.1 In the case of Triology E-Business Software India (P.) Ltd. (supra), Coordinate Bench decided companies as not comparable on High turnover, with respect to

10. iGate Global Solutions Ltd. (747.27 crores),
11. Mindtree Ltd. (590.39 crores),
12. Persistent Systems Ltd. (293.74 crores),
13. Sasken Communication Technologies Ltd. 343.57 crores).
The Bangalore Bench of the Tribunal held as under :

"20. In this regard we find that the provisions of law pointed out by the ld. counsel for the assessee as well as the decisions referred to by the ld. counsel for the assessee clearly lay down the principle that the turnover filter is an important criteria in choosing the comparables. The assessee's turnover is Q 47,46,66,638. It would therefore fall within the category of companies in the range of turnover between 1 crore and 200 crores (as laid down in the case of Genesis Integrating Systems (India) (P.) Ltd. v.DCIT, ITA No.1231/Bang/2010) . Thus, companies having turnover of more than 200 crores have to be eliminated from the list of comparables as laid down in several decisions referred to by the ld. counsel for the assessee. Applying those tests, the following companies will have to be excluded from the list of 26 comparables drawn by the TPO."

14. HELIOS & MATHESON information Technology ltd.

"This comparable is objected on the reason of low employee cost of 1.36%. Thus it fails the employee cost filter. Therefore, not comparable. Assessee relied on the judgment of Mentor Graphics P. Ltd. v.DCIT 109 ITD 101 (Del.) with reference to this comparable."

15. After considering the contentions, we are of the opinion that these 14 comparables are required to be excluded by the TPO. Respectfully following the decisions of the Coordinate Benches of the Tribunal, we direct that these companies should be excluded from the list of comparables as assessee turnover is only 2.18 crores and employee cost is more. Many of the companies are also found to be not functionally similar. The various filters and reasons accepted in other cases do apply to the assessee as TPO selected same 26 comparables in all the cases relied on and decided earlier in various cases.

16. Respectfully following the Coordinate Bench decisions in the above companies, we direct that these 14 companies should be excluded from the computation of PLI. It was submitted that the mean PLI of the rest of the comparables selected by the TPO would come to 18.66% and this is within the margin as arrived at by the assessee. after excluding the R&D cost contested above. However, these aspects require examination by the TPO as the issue of 'operating cost' has a bearing on working the ALP. The AO/TPO is directed to determine the operating cost as directed above and then workout the arithmetic mean of the comparables accepted above after rejecting the comparables as discussed in the above paras. Thereafter, A.O/TPO is directed to examine whether any adjustment is required under the provisions of the Act toward working capital. Eventhough, assessee has not raised specific objections about negative working capital adjustment before us, though a ground was raised, in the charts it taken the negative working capital as such. However, in the revised T.P. computation if required A.O. can also examine this aspect of negative working capital adjustment which was duly objected before the DRP. With these observations, grounds are considered as allowed for statistical purposes.

17. Ground no 5 is with reference to not setting of losses carried forward. This also requires verification by AO of earlier orders/ record. AO is directed to do the needful as per facts and law. Ground is allowed for statistical purposes.

18. In the result, appeal of the assessee is allowed for statistical purposes.

The order pronounced in the open court on May 28, 2014.