Financial health can never be a criterion to judge allowability of an expense

IN THE ITAT Mumbai Bench ‘K’

Thyssen Krupp Industries India (P.) Ltd.

Versus

Assistant Commissioner of Income-tax

IT APPEAL NO. 7032 (MUM.) OF 2011

[ASSESSMENT YEAR 2007-08]

NOVEMBER 27, 2012

ORDER

Per Bench 

This is an assessee’s appeal against the order of AO under section 143(3) r.w. section 144C(13) dated 29.09.2011 in pursuance of the directions of the Dispute Resolution Panel (DRP). In the course of appeal proceedings, assessee filed the revised and concise grounds of appeal which are as under:

 1.  “The Asstt. Commissioner of Income Tax – 3(3), Mumbai (‘AO’) erred in making a Transfer Pricing (‘TP’) adjustment of Rs. 9,67,80,0001- in relation to import of spares and equipment 1 Entity level profitability.

 2.  The AO erred in disregarding the segmental data provided by the Appellant.

 3.  The AO erred in not restricting the TP adjustments only to the transactions between the Associated Enterprises (‘AEs’).

 4.  The AO erred in making TP adjustment of Rs. 11,27,16,302 in relation to payment of royalty and project engineering and manufacturing drawing fees.

 5.  Without prejudice to Ground No.4, the AO erred in making a double adjustment of Rs. 11,27,16,302 in relation to payment of royalty and project engineering and manufacturing drawing fees.

 6.  The AO erred in making a TP adjustment of Rs. 2,70,38,800 in relation to payment of liquidated damages.

 7.  Without prejudice to Ground No.6, the AO erred in making a double adjustment in respect of payment of liquidated damages of Rs. 2,70,38,800.

 8.  The AO erred in making TP adjustment of RS.32,359 by adding notional interest on payment received from AE.

 9.  The AO ought to have granted the 5% standard deduction under Section 92C(2) of the Act.

10.  The reference to the Transfer Pricing Officer under Section 92CA by the AO was bad in law, in excess of jurisdiction and/ or void in law”.

2. We have heard the Learned Counsel Shri P.J. Pardiwala and the Learned CIT (DR) Shri Ajeet Kumar Jain in detail and perused the paper book containing pages 1 to 555. The issue in the present appeal is with reference to transfer pricing adjustments made by AO consequent to the orders of the TPO and the DRP.

3. Briefly stated, assessee is a member of Thyssen Krupp Technologies, a business segment of the Thyssen Krupp AG of Germany. It executes turnkey contracts involving design, manufacture, supply, erection and commissioning of sugar plants, cement plants, mining and bulk material handling equipment, steam generators etc. On reference under section 92CA(1) of the I.T. Act 1961, vide order dated 28.10.2010 adjustments were made on the following transactions assessee had with Associated Enterprises(AEs):-

  •  Import of spares and equipments/Entity level profitability adjustment of Rs. 9,67,80,000).

  •  Royalty and project engineering and manufacturing drawings (adjustment of Rs. 11,27,16,302),

  •  Settlement for liquidity damages (adjustment of Rs. 2,70,38,000).

  •  Interest on delayed payments (adjustment of Rs. 32,359).

Total adjustments came to Rs. 23,65,67,461. The objections are in this backdrop.

4. Assessee objected to various additions proposed before the DRP.

(A)  With reference to the adjustment on import of spares and equipments of Rs. 9,67,80,000 it was the submission that the entire amount was arrived at after bench marking, using TNMM method, at the entity level and operational profits attributable to international transactions by determining the Arm Length Price(ALP) is much less than what was proposed by TPO on entire sales turnover and if modified is within the range of +/- 5% as per second proviso to Sec 92C(2). The DRP however, did not agree on the reason that the TPO’s view was to be accepted as the proportion of adjustment has to be done at the entity level and therefore there is no need to vary from the observations of the TPO. Segmental data provided to the DRP was also not accepted.

(B)  With reference to the adjustments made on transactions with AE for availing manufacturing and drawing and project engineering services and knowhow, it was the submission that assessee obtained the knowhow and project engineering drawings from its AE vide a collaboration agreement dated 23.07.1996. Assessee paid AE at 2% of the contract value for the manufacturing drawings & project engineering services and royalty @5% of the selling price. Even though it was submitted that specific FIPB approval has been obtained and they were no adjustments on this transactions in earlier years, the TPO as well as the DRP did not agree and disallowed the entire amount as the arm’s length price was taken at NIL and accordingly made adjustment of Rs. 11.2 crores.

(C)  The next issue is of liquidated damages. Assessee made payment to its AE on account of liquidated damages paid by the AE to Neyveli Lignite Corporation Ltd (NLC), the third party on account of deals made on two contracts. The background is that NLC gave contract to M/s Krupp Fordertechnik GmbH, Germany (KF) for design and supply of two Bucket Wheel Excavators (BWE). As per this contract KF was to supply products to NLC. There was another agreement according to which assessee was to supply a few components of BWE. There was a delay in supply of BWE and as a consequence, NLC charged damages on KF. According to assessee the delay occurred in supply to NLC is due to technical reasons and as liquidated damages were deducted from KF payments by NLC, assessee was liable to reimburse the same to KF. The TPO did not agree. The arms length price was determined at Nil and made an adjustment of Rs. 2,70,38,800. It was the submission before the DRP that this is a business decision and the amount paid to KF was same amount deducted by the NLC. This argument was not accepted and the DRP confirmed the same.

(D)  In addition to the major three amounts mentioned above, there was another addition made by the TPO on levy of interest in respect of reimbursements of expenses as TPO found that there was time gap between expenses incurred and the amount received by assessee and on that delay an amount of Rs. 32,359/- was made as adjustment which was confirmed by the DRP. The present appeal is with reference to the above action of the TPO and the DRP in making transfer pricing adjustments.

5. The learned Counsel referred to the sequence of events, the TP study, the selection of variables, revised selection of variables, change of data from three years to the relevant assessment year’s data before the TPO to submit that assessee in the TP report has bench marked its transactions at the entity level on nine comparables which earned a mean profit margin of 4.12% as against assessee’s margin of 5.19%. In view of the updated data and rejection of three comparables, the TPO has arrived at the revised mean margin at 6.29% as against assessee’s margin of 5.19%. Therefore, he proposed to make adjustment of Rs. 9,67,80,000 on the entire turnover of the entity. Referring to the page No.66 of the document filed along with the appeal memo, it was the submission that assessee had total sales of Rs. 883.6 crores and operating expenses were to the tune of Rs. 837.7 crores. Assessee had an operating profit of Rs. 45.9 crores. Out of the operating expenses, payments made to AE are only Rs. 35.5 crores which is less than 5% of assessee’s turnover. It was submitted that the TPO & DRP wrongly affirmed the adjustment on the entire sales turnover of assessee, thereby making addition at that amount. In fact they should have restricted to the transactions with the AE alone. On this preliminary issue itself, the learned Counsel submitted that the ALP fixed on international transactions is within the +/- 5% range as per the proviso to section 92C(2) of the Act and referred to same page to explain the working. It is also a contention that the TP adjustment cannot be made on the entire sales of the organization whereas only 5% of the turnover pertain to the payments made to AE. If the adjustment was restricted to the international transactions alone, then there will be no need for any adjustment at all under the TP provisions. He relied on the following decisions to submit that the TP addition cannot be made on the entire turnover of the entity, whereas that should be restricted to AE transaction alone on pro rata basis.

 1.  DCIT v. Starlite (40 SOT 421 (Mum)

 2.  DCIT v. Ankit Diamonds (43 SOT 523 (Mum)

 3.  Addl. CIT v. Tej Dam (37 SOT 341 (Mum)

 4.  M/s Genesys Integrating Systems (India) Pvt. Ltd (ITA No.1231/Bang/2010)

 5.  ACIT v. Wockhardt Ltd (6 Taxman.com 78 ITAT (Mum)

 6.  Abhishek Auto Industries Ltd (2010 TII-54-ITAT (Del)

 7.  DCIT v. Startex Networks (India) Pvt. Ltd (2010 – TII-13 ITAT (Del).

 8.  Il Jin Electronics(I) Ltd v. ACIT 36 SOT 227(Delhi)

 9.  Phoenix Mecano (India) Ltd. v. Deputy Commissioner of Income-tax, 49 SOT 515

10.  Lion Bridge Technology Ltd – 9032/10

6. With reference to the other adjustments in addition to the arguments raised before the TPO and the DRP, it was also submitted that once the adjustments are made at the entity level, AO was precluded in making item-wise adjustments as was done by TPO on royalty payments and on liquidated damages. The learned Counsel relied on the judgment of the Hon’ble Delhi High Court in the case of CIT v. EKL Appliances Ltd, 2012 – TII – 01-HC Del-TP 29/03/2012 to submit that under the TP provisions and Rule 10B, AO cannot invoke the provisions of section 37(1) to determine the ALP at Nil. It was the submission that the action of AO and the DRP in making adjustments of the above amounts is not correct both on the reason that the entity level adjustment was made considering the operating cost (including these amounts) and further ALP cannot be determined at Nil as was done by the TPO. In view of this it was the submission that the adjustments are not required to be made.

7. The learned AR also justified the said payments on facts which were also placed before the TPO and the DRP. With reference to the interest adjustment made it was the submission that there are no loans granted to the AE and is only the credit which AO considered as loan. However, being a small amount added by AO, the learned Counsel did not press the issue seriously at the time of arguments.

8. The learned Counsel also referred to the segmental data provided to the DRP in order to support its contention that assessee’s profits are more than the comparable’s profit. It was submitted that segmental data was not considered by the DRP, even though audited accounts were furnished. Another argument of the learned Counsel is with reference to arriving at the operating profits by excluding the losses incurred in the local projects. He referred to the submissions made before the DRP that assessee has incurred huge losses in two local projects and if these losses in the projects were excluded, then assessee’s profit margin was more than the margin arrived at by the comparables.

9. The learned DR however, relied on the orders of the TPO and the DRP to submit that once entity level TNMM was considered adjustment was to be made on the entire transactions. Therefore, the action of AO was justified. With reference to the segmental data it was submitted that even though the certificate was furnished the verification of the data was not complete as these are not placed before the TPO. He then referred to the segmental data provided in the annual report to submit that this is not the standard segmental data and therefore cannot be accepted. The learned DR however, submitted that the mean margin arrived at from the comparables on TNMM method was not in dispute. Therefore, the addition so made is justified on the facts of the case.

10. With reference to the royalty and the liquidated damages, it was the submission that the TPO was correct in analyzing the individual transactions even though entity level adjustment was made and ALP on these transactions was determined at Nil.

11. In reply, the learned Counsel submitted that the audit report was submitted as per the company law and the certificates were furnished as provided under the law. The segmental data as required for the TP study was not part of either company law or under the I.T Act and these segmental data were taken for the purpose of analyzing internal and external comparables and to bench mark the transactions. The objection of the DR that this segmental data is not as prescribed is not valid as assessee has duly furnished the relevant segmental data in line with the comparables on FAR analysis and so these are to be accepted.

12. On a query from the Bench whether the relevant royalty payments made on various projects were also taken into account in segmental data, the learned Counsel fairly admitted that these payments were not taken into account.

13. We have considered the issue and examined the various arguments placed before the authorities as well as before us including the details furnished in the paper book. There is no dispute with reference to applying TNMM method and assessee being a tested party, applying the profit margin on the operating expenses at the entity level. On various propositions made by the learned Counsel, we agree with the argument that the adjustments are to be restricted to international transactions alone and cannot be applied to the entire turnover of the company. On the facts of the case assessee’s transactions with third parties constitute more than 95% and with AEs less than 5%. Therefore, adjustment made by the TPO on the entire turnover of the entity without restricting to the international transactions is not correct according to facts and law. This issue was already discussed elaborately by various Coordinate Benches in cases referred by Ld. Counsel above. The ITAT in the case of IL Jin Electronics (I) (P.) Ltd. v. Assistant Commissioner of Income-tax, Circle-11(1), New Delhi, [2010] 36 SOT 227 (DELHI) held as under:

“The assessee had also taken an alternative ground that out of the total raw materials consumed by it for manufacturing print circuit boards, only 45.51 per cent of the total raw materials was imported through the assessee’s associate concerns, and, therefore, any adjustment, if any called for, could only be made to the 45.51 per cent of the total turnover, and not to its total turnover. After considering the facts of the case, there was no difficulty in accepting the contention of the assessee that at best only 45.51 per cent of the operating profit could be attributed to imported raw materials acquired from the assessee’s associate concerns. In the instant case, the Assessing Officer had calculated the operating profit on the entire sales of the assessee, which was not justified, when it was an admitted position that only 45.51 per cent of raw materials had been acquired by the assessee from its associate concerns for the purpose of manufacturing items. The assessee had stated that the operating profit if applied to 45.51 per cent of the turnover would come to Rs. 35,52,573 as against operating profit of Rs. 24,35,175 booked by the assessee, and the difference thereof would only be called for to be made as an addition to the profit shown by the assessee. Therefore, the Assessing Officer was to be directed to modify the assessment and make the adjustment only to the extent of the difference in the arm’s length operating profit adjusted with reference to the 45.51 per cent of the turnover, and not to the total turnover of the assessee. Therefore, to that extent, the addition made by the Assessing Officer and further confirmed by the Commissioner (Appeals) was to be reduced.”.

14. Further, this issue was already crystallized in favour of assessee by the following decisions:

(a)  DCIT v. Starlite (40 SOT 421 (Mum)

(b)  DCIT v. Ankit Diamonds (43 SOT 523 (Mum)

(c)  Addl. CIT v. Tej Dam (37 SOT 341 (Mum)

(d)  M/s Genisys Integrating Systems (India) Pvt. Ltd (ITA No.1231/Bang/2010)

(e)  ACIT v. Wockhardt Ltd (6 Taxman.com 78 ITAT (Mum)

(f)  Abhishek Auto Industries Ltd (2010 TII-54-ITAT (Del)

(g)  DCIT v. Startex Networks (India) Pvt. Ltd (2010 – TII-13 ITAT (Del).

(h)  Phoenix Mecano (India) Ltd. v. Deputy Commissioner of Income-tax, 49 SOT 515

(i)  Lion Bridge Technology Ltd – 9032/10

15. Respectfully following, whatever be the method followed or adopted for arriving at the ALP, the ALP can only be determined on the value of international transactions alone and not on the entire turnover of assessee at entity level. If this sort of adjustment is permitted, this will result in increasing the profit of assessee on the entire non-AE transactions also, which is not according to the provisions of Transfer Pricing mandated by the Act. In view of this the action of the TPO supported by the DRP in making the adjustment of Rs. 9,67,80,000 is not correct. This should be restricted to the AE transactions only. As rightly pointed out, the finally comparables margin on the updated data arrived at by the TPO was 6.29% as against assessee’s margin of 5.19%. Therefore, the addition on margin of 1.10% can only be determined on the AE transactions.

16. The next argument is with reference to the application of proviso to section 92C(2). This argument even though was raised before the TPO as well as DRP, they have not considered the issue in the correct perspective as they have applied the margins on the entire sales of assessee, naturally the ALP determined also was high. The correct working should be like this:

Based on the arm’s length margin of 6.29%, the arm’s length profit would be Rs. 55.6 crs (883.6 * 6.29%) and accordingly the arm’s length operating costs would be Rs. 828.0 crs (883.6 – 55.6). The said arm’s length price of operating cost has been apportioned between AE and non AE on the basis of the cost ratio. The working of the same is as under:

(Rs. in crs)

The variation between the arm’s length price for AE transaction i.e. Rs. 35.10 Crs and the value of international transaction i.e. Rs. 35.50 Crs does not exceed 5% of the former and is within the range. Accordingly, assessee has after exercising its option as per the proviso to section 92C(2) of the Act complies with the arm’s length standard required by the Transfer Pricing Regulations.

17. Since the ALP determined at Rs. 35.10 crores is within the +/- 5% range of the AE transactions of Rs. 35.5 crs, there is no need for any adjustment to be made on the said transactions. In view of this the adjustment proposed at Rs. 9,67,80,000 requires to be cancelled.

18. With reference to the adjustment for the royalty payment and liquidity damages, we agree with the submission of assessee that these adjustments are not required. As far as facts are concerned, assessee entered into a collaboration agreement dated 23.07.1996 for payment of 2% of contract value for the manufacturing drawing & engineering services and 5% of the selling price as royalty. This agreement was approved by FIPB and the payments are being made in earlier years. As submitted before the TPO, this is the 5th year of TP study and there was no adjustment made in the earlier years. On facts, the payment of 2% of contract value and 5% of selling on royalty should have been bench marked if at all, on the similar payments with the comparable cases. No such exercise was undertaken by the TPO. Further the learned Counsel relied on the order of the ITAT in the case of Castrol India Ltd in ITA No.3938/Mum/ 2010 for the proposition that it is incumbent upon the TPO to work out the ALP of relevant transactions by following the some authorized method and the entire cost borne by assessee cannot be disallowed by taking the ALP at Nil. This aspect was already decided by the Hon’ble Delhi High Court in the case of EKL Appliances. Therefore, there is no need to extract the ITAT order placed before us. The Hon’ble Delhi High Court in the case of DCIT v. EKL Appliances Ltd 2012 TII-1 High Court Del. TP 29-03-2012, has held as under:

“19. There is no reason why the OECD guidelines should not be taken as a valid input in the present case in judging the action of the TPO. In fact, the CIT (Appeals) has referred to and applied them and his decision has been affirmed by the Tribunal. These guidelines, in a different form, have been recognized in the tax jurisprudence of our country earlier. It has been held by our courts that it is not for the revenue authorities to dictate to the assessee as to how he should conduct his business and it is not for them to tell the assessee as to what expenditure the assessee can incur. We may refer to a few of these authorities to elucidate the point. In Eastern Investment Ltd. v. CIT, [1951] 20 ITR 1, it was held by the Supreme Court that “there are usually many ways in which a given thing can be brought about in business circles but it is not for the Court to decide which of them should have been employed when the Court is deciding a question under Section 12(2) of the Income Tax Act”. It was further held in this case that “it is not necessary to show that the expenditure was a profitable one or that in fact any profit was earned”. In CIT v. Walchand & Co. etc., [1967] 65 ITR 381, it was held by the Supreme Court that in applying the test of commercial expediency for determining whether the expenditure was wholly and exclusively laid out for the purpose of business, reasonableness of the expenditure has to be judged from the point of view of the businessman and not of the Revenue. It was further observed that the rule that expenditure can only be justified if there is corresponding increase in the profits was erroneous. It has been classically observed by Lord Thankerton in Hughes v. Bank of New Zealand, [1938] 6 ITR 636 that “expenditure in the course of the trade which is unremunerative is none the less a proper deduction if wholly and exclusively made for the purposes of trade. It does not require the presence of a receipt on the credit side to justify the deduction of an expense”. The question whether an expenditure can be allowed as a deduction only if it has resulted in any income or profits came to be considered by the Supreme Court again in CIT v. Rajendra Prasad Moody, [1978] 115 ITR 519, and it was observed as under: –

“We fail to appreciate how expenditure which is otherwise a proper expenditure can cease to be such merely because there is no receipt of income. Whatever is a proper outgoing by way of expenditure must be debited irrespective of whether there is receipt of income or not. That is the plain requirement of proper accounting and the interpretation of Section 57(iii) cannot be different. The deduction of the expenditure cannot, in the circumstances, be held to be conditional upon the making or earning of the income.”

It is noteworthy that the above observations were made in the context of Section 57(iii) of the Act where the language is somewhat narrower than the language employed in Section 37(1) of the Act. This fact is recognised in the judgment itself. The fact that the language employed in Section 37(1) of the Act is broader than Section 57(iii) of the Act makes the position stronger.

In the case of Sassoon J. David & Co. Pvt. Ltd. v. CIT, [1979] 118 ITR 261 (SC), the Supreme Court referred to the legislative history and noted that when the Income Tax Bill of 1961 was introduced, Section 37(1) required that the expenditure should have been incurred “wholly, necessarily and exclusively” for the purposes of business in order to merit deduction. Pursuant to public protest, the word “necessarily” was omitted from the section.

21. The position emerging from the above decisions is that it is not necessary for the assessee to show that any legitimate expenditure incurred by him was also incurred out of necessity. It is also not necessary for the assessee to show that any expenditure incurred by him for the purpose of business carried on by him has actually resulted in profit or income either in the same year or in any of the subsequent years. The only condition is that the expenditure should have been incurred “wholly and exclusively” for the purpose of business and nothing more. It is this principle that inter alia finds expression in the OECD guidelines, in the paragraphs which we have quoted above.

22. Even Rule 10B(1)(a) does not authorise disallowance of any expenditure on the ground that it was not necessary or prudent for the assessee to have incurred the same or that in the view of the Revenue the expenditure was unremunerative or that in view of the continued losses suffered by the assessee in his business, he could have fared better had he not incurred such expenditure. These are irrelevant considerations for the purpose of Rule 10B. Whether or not to enter into the transaction is for the assessee to decide. The quantum of expenditure can no doubt be examined by the TPO as per law but in judging the allowability thereof as business expenditure, he has no authority to disallow the entire expenditure or a part thereof on the ground that the assessee has suffered continuous losses. The financial health of assessee can never be a criterion to judge allowability of an expense; there is certainly no authority for that. What the TPO has done in the present case is to hold that the assessee ought not to have entered into the agreement to pay royalty/brand fee, because it has been suffering losses continuously. So long as the expenditure or payment has been demonstrated to have been incurred or laid out for the purposes of business, it is no concern of the TPO to disallow the same on any extraneous reasoning. As provided in the OECD guidelines, he is expected to examine the international transaction as he actually finds the same and then make suitable adjustment but a wholesale disallowance of the expenditure, particularly on the grounds which have been given by the TPO is not contemplated or authorized”.

Keeping in mind the principles laid down above, we are of the view that the TPO should not have undertaken determining the ALP at nil whereas the jurisdiction provided to him is to determine the ALP of the transactions under the method(s) provided under the Act. Therefore, on legal principles also this adjustment made by AO cannot be upheld. Therefore, this is deleted.

19. Similar is with the case with reference to the liquidated damages. There is no dispute with reference to the payment of liquidated damages to NLC. NLC is having agreement with the principal KF for supply of Bucket Wheel Excavators (BWE) and delay in supply was held to be on behalf of assessee. Since the amount was deducted by the NLC from the payments being made to KF, assessee has to necessarily reimburse the payment to KF. It has reimbursed the same amount what was deducted by NLC from KF. As far as TP provisions are concerned on facts, this adjustment cannot be made as assessee has paid the same amount which was recovered by NLC as third party. Whether the liquidated damages are to be paid by assessee or not is a business consideration to be examined under section 37(1). This aspect, as considered by the Delhi High Court in the case of EKL Appliances (supra), is also outside the purview of the TP provisions as payment of liquidity damages to KF is a business decision taken by assessee and in our view it is necessary for the purpose of business, in view of the ongoing agreements with the NLC. Since assessee reimbursed the exact amount which was recovered by NLC, we are of the opinion that no adjustment can be made both on facts and on law. Therefore, AO’s disallowances of the entire amount of Rs. 2,70,38,800 cannot be supported. One of the argument by the TPO is that the settlement deed does not clarify how the Euro 4,60,000 has been quantified. The entire data was placed before AO and there is no dispute with reference to the facts. In view of this, we are of the opinion that adjustment of the liquidated damages at Nil also cannot be upheld.

20. The argument which was raised that once the TP adjustment was made at the entity level, individual adjustment of royalty and liquidity damages cannot be made again has some merit. However, this aspect will be examined in an appropriate case. Therefore, without giving any observation or findings on this argument, we are of the opinion that on facts and on law as discussed above, there is no need for making adjustments on the payments made towards manufacturing drawing and technical services and royalty and liquidity damages as was done by the TPO determining the ALP at nil. AO is directed to delete the same.

21. There is a small adjustment of Rs. 32,359 being the notional interest on payment received from AE. Considering the smallness of the amount as this was not seriously argued, without going into the merits of the above and legal principles thereon, we confirm the addition so made.

22. The learned Counsel has placed various data, selling expenses to sales analysis, profitability statement between AE and Non AE to justify the submissions made before the DRP. We are of the opinion that there is no need for discussion on these elaborate submissions and accordingly, even though they have been considered, they were not specifically discussed in the order. With reference to segmental data provided before the DRP, we notice that the same is not prepared taking the royalty @5% on sales in the project expenditure. This will have an impact on cost working as well as profit margin. We are of the view that segmental data need not be taken into account on the facts of the case. In the result, assessee’s grounds 1 to 7 are allowed. Ground 8 is rejected. Ground 9 and 10 does not require any adjudication. AO is directed to modify the order accordingly.

23. In the result appeal filed by assessee is partly allowed.