ITAT Chennai Rules Against Recharacterization of Software Development Services: Transfer Pricing Adjustment Reversed

Introduction

The Income Tax Appellate Tribunal, Chennai Bench, delivered a significant ruling in the matter of Scientific Games India Private Limited Vs DCIT, addressing the contentious issue of business recharacterization in transfer pricing proceedings. The Tribunal concluded that reclassifying an entity's business operations from 'software development service provider' to 'contract R&D service provider' lacks justification when prior assessments and bilateral advance pricing agreements consistently recognize the original characterization. Consequently, the upward transfer pricing adjustment amounting to Rs.25,26,64,677/- was set aside.

Background of the Case

Scientific Games India Private Limited, established in 2005, operates as a wholly-owned subsidiary of Bally Technologies Inc., USA (presently operating as LNW Gaming Inc.). The entity functions as a 100% Export Oriented Undertaking registered under the Software Technology Park of India scheme, with operational centers located in Chennai and Bangalore.

The company's primary business activity involves executing software development agreements with its associated enterprises, wherein it undertakes coding, decoding, debugging, and quality testing functions for group entities. For Assessment Year 2014-15, the assessee filed its return declaring total income of Rs.40,39,02,110/- on November 29, 2014. Subsequently, the case underwent scrutiny assessment under CASS and was referred to the Transfer Pricing Officer.

Transfer Pricing Analysis by the Assessee

During the transfer pricing assessment, the assessee conducted comprehensive functional, asset, and risk analysis. Based on this evaluation and data availability, the Transactional Net Margin Method was determined as the most suitable methodology. Operating profit to total operating costs was selected as the appropriate Profit Level Indicator.

The assessee undertook detailed comparable company searches in public databases, identifying six independent enterprises engaged in software development services. The arithmetic mean OP/OC margins of these comparable entities stood at 10.02%, whereas the assessee's margin was 13.72%. Given that the assessee's margin exceeded the arithmetic mean of comparables, the international transactions were deemed to satisfy arm's length criteria from an Indian transfer pricing perspective.

TPO's Recharacterization and Fresh Analysis

The Transfer Pricing Officer invoked Exchange of Information provisions under the Double Tax Avoidance Agreement, requesting details from the US Internal Revenue Service. This action extended the assessment completion timeline under Explanation 1(x) to Section 153(9) of the Income Tax Act 1961.

Through information exchange, the TPO obtained Global Transfer Pricing documentation. Relying on this documentation, the TPO reclassified the assessee's business as a Contract R&D service provider, subsequently conducting fresh searches for companies engaged in software research and development activities. This resulted in rejection of the software development search undertaken by the assessee.

The TPO ultimately selected nine comparable companies with arithmetic mean OP/OC margins of 26.87%. After treating foreign exchange gains as operating in nature, the assessee's margins were increased from 13.72% to 15.11%. This led to an upward transfer pricing adjustment of Rs.25,26,64,677/- reflecting the margin differential.

Draft Assessment and DRP Proceedings

The Assessing Officer issued a draft assessment order dated September 24, 2018, incorporating the upward transfer pricing addition of Rs.25,26,64,677/- made by the TPO. Additionally, finance lease rent payment amounting to Rs.62,55,408/- was disallowed.

The Dispute Resolution Panel rejected the transfer pricing grounds raised by the assessee. However, regarding corporate tax matters, while disallowing the assessee's grounds treating finance lease payment as revenue expenditure, the DRP allowed the alternate ground, permitting depreciation by considering it capital expenditure. The final assessment order dated July 4, 2019, incorporated these modifications, prompting the present appeal.

Grounds of Appeal

The assessee challenged multiple aspects before the Tribunal, including:

Transfer Pricing Grounds

Recharacterization Issues:

  • The authorities failed to recognize that the inter-company agreement obligated the assessee only to provide software development assistance without any R&D obligations
  • The conclusion that employees engaged in high-end work based solely on 86.5% employee cost composition ignored industry norms for service providers
  • Classification as risk-bearing entity disregarded the fact that the assessee receives full operating costs plus markup irrespective of product success or failure
  • Different approach from previous assessments without factual changes in business operations
  • Recharacterization based merely on terminology used in Global Transfer Pricing documentation