How to find uncontrolled comparables

Following steps can be adopted to find uncontrolled comparables

STEP I
Selection of Tested parties
Normally, the tested party’s profitability should be verified using the most reliable data available that require the fewest and most reliable adjustments. In most cases, the tested party will be the less complex of the parties having international transactions and will not own valuable intangible or unique assets that distinguish it from potential comparable companies.

Based on the functional analysis contained in section 3 above and our understanding of the international transactions, we selected Quark India, the less complex of the two related entities, as the tested party for the purpose of our analysis.
The search for comparable uncontrolled skilled service provides relied primarily on an electronic database named ‘Prowess’ developed by Centre for Monitoring of Indian Economy (CMIE) Private Limited, that contain financial information on publicly-owned companies, generally obtained from documents filed with appropriate government agencies.

Prowess is a database of large and medium sized companies in India, (over 7,000 in number) encapsulated in software developed by CMIE to facilitate financial, industrial and investment analysis. Prowess provides a highly reliable database built by researchers at CMIE under a rigorous system of normalization and validation.

The database search was supplemented by an examination of selected secondary sources that might assist in the identification of potential comparables and/or provide additional functional or financial about previously identified potential comparables. Where appropriate, actual documents filed with government agencies were reviewed in detail. The secondary sources also included Enquiry Research Section (ERS), a financial and qualitative database of over 7,000 listed and unlisted companies in India, developed by Asian CERC information Technology Limited.

Step II
Search for comparable companies
The first step in searching uncontrolled comparable companies is to identify a large set of potentially comparable companies based on company’s main activity with the help of electronic database available. In India two reliable database known as Prowess Database by Centre for Monitoring Indian Economy

The objective of our search for comparable independent companies was to identify publicly available data in respect of independent companies that undertake software development services, operate in similar markets and bear risks similar to that of Quark India.

We employed the Centre for Monitoring Indian Economy’s PROWESS database to identify the potential comparable independent companies. PROWESS contains financial data of over 8,100 largely publicly traded Indian companies. The data is collected from annual/quarterly results, Government reports and other sources.
We structured our search under this database to cover ‘Company’s Main Activity’ as well as ‘Products Manufactured/Traded etc.’ We considered all the companies classified under the following heading:

• Computer software; and

• Software services and consultancy

Capitaline Plus

We further employed the Capitaline Plus database to identify the potential comparable companies. Capitaline Plus contains financial data of over 8,000 largely publicity traded Indian companies. The data is collected from annual/quarterly results, government reports and other sources.
We considered all the companies classified under the following heading:

• Computer Software-Converts;

• Computer Software-Large; and

• Computer Software-Medium and Large.

This search yielded a list of 446 companies. These companies were analysed as below:

• Of these 446 companies we eliminated all the companies, which were part of initial set in Search 1 and hence have been already analysed. This process eliminated a total of 298 companies leaving a set of 148 companies.

• 45 companies in Search 1 were rejected on account of insufficient financial information or director’s report were not available in the Prowess Database. Of these 45 companies, 38 companies were available in Caplitaline Plus database. Thus the total companies, which were analysed in Capitaline Plus database, were 186.

• Out of these 186 companies, 73 companies did not have their financials for year ending 31 March 2002 and thereafter. The details of these companies are available in Appendix D. Thus after eliminating  the companies on account of insufficient financial information we were left with 113 companies.

Step III

Elimination of Comparable companies through Qualitative and Quantitative Screening

Qualitative

• Quantitative screening is a process under which comparability is assessed by comparing economically significant financial data or ratios. The data used in this process, as well as in our financial analysis is documented in Appendix E.

• To insure comparability, companies with the following characteristics were eliminated.

• had significant manufacturing activity for the period examined, because companies that have significant income from manufacturing activity rend to distort the economic returns as these companies bear a higher amount of risk because of there capital intensive nature. In addition, a higher manufacturing activity signifies that the company’s nature of operations is highly diversified and hence the risks assumed are also significantly different from a pure services company. In this step companies having manufacturing sales to total sales ratio of more than 40% were eliminated.

• companies with high trading activity were also not considered, as these companies would be more involved in distribution services than sales and support or other value added services. In this step companies having trading sales to total sales of more than 40% were eliminated.

• had a ratio of research and development expenses to sales that exceeded 3 % indicating the possible ownership of intangibles and/or significant activities not involved in pure service provision;

• had a net fixed assets to sales that exceeded 200%, indicating that these companies did a significant amount of manufacturing or otherwise held substantial assets not used in providing services;

• had average sales of less than INR 1 crore is during the time period because low sales volumes may indicate that the companies are starting up operations. Moreover, the reliability of the financial data for companies with low levels of sales can be significantly reduced because the same persons are often both major shareholders and key employees, diminishing the economic distinction between profits and salaries.

Quantitative
in our qualitative review process (Refer Appendix F for details): -

Thus our qualitative screening eliminated 80 companies from the balance set of 82 companies, leaving a final set of 2 broadly comparable companies mentioned below:

1. M Y  N Technologies Limited;
2. Telesys Software Limited.

Thus as a result of search 1 and 2, we have obtained a final set of 17 broadly comparable independent companies, which are listed as below:

1. Blue Star Infotech Limited
2. California Software Co. Limited
3. Capricorn Systems Global Solutions Limited
4. Compucom Software Limited
5. Fore C Software Limited
6. Helios & Matheson Information Technology Limited
7. Hexaware Technologies Limited
8. Infotech Enterprise Limited
9. M Y N Technologies Limited
10. Mastek Limited
11. Megasoft Limited
12. Mphasis B F L Limited
13. Omni Ax’S Software Limited
14. Orient Information Technology Limited
15. Telesys Software Limited
16. Visualsoft Technologies Limited
17. Zigma Software Limited

Step IV

Adjustments
For the purpose of this analysis, data of comparable companies pertaining to financial years ending during the two-year period 2000 through 2001 have been used. However, the transaction of the company being benchmarked relates to the financial year 2001-2002. Hence, specific adjustment to account for change in prevailing economic conditions becomes necessary. The details of the adjustment is given Appendix F.
Determination of Arm’s length Operating results
The Indian Regulations require that the Arm’s Length Price (ALP) in relation to an international transaction shall be determined by any of the prescribed methods (CUP, RPM, Cost Plus, TNMM and Profit Split Method), being the most appropriate method

Step V

Determination of arm length operating results

Brief business descriptions, financials and companies of the average NCP margins of the final set of comparables are attached as Appendix G and Appendix H, respectively.

On the basis of the above, the weighted average NCP margins range from 0.89 percent to 38.20 percent with an arithmetic mean of 12.38 percent.

For the year ended 31st March 2004, the profit7 earned by Quark India from software development services is shown below:

Particulars	Amount (Rs)
Income Sales Miscellaneous Income Total                                                     (A) Expenditure Personal Expenses Administration and Other Operating Expenses Depreciation Bank Charges Preliminary Expenses Written off   Total                                                     (B) Net Profit                          (C )= (A)-(B) NCP (%)                           (C )/(B)* 100	407,287,882          41,888   407,329,770   244,472,686   88,151,055   26,028,831        125,941            9,509 358,788,022   48,541,748          13.53

On the basis of the above, for the year ended 31 March 2004, Quark India has earned NCP margin of 13.53 percent from its software related research and development services which is higher that the aforesaid arithmetic mean of 12.38 percent. Accordingly, it is reasonable to conclude that the outcome of Quark India’s international transactions pertaining to software development services appear to be consistent with the arm’s length standard.

The Indian Regulations require that the Arm’s Length Price (ALP) in relation to an international transaction shall be determined by any of the prescribed methods (CUP, RPM, Cost Plus, TNMM and Profit Split Method), being the most appropriate method.