Transfer Pricing: Revenue can’t adjust operating costs in allowing capacity adjustment

Brief of the case:

In the case of DCIT Vs. Claas India Pvt. Ltd. Delhi Bench of ITAT have denied to approve the method adopted by AO/TPO in allowing capacity adjustments. ITAT further held that once the law enjoins for doing a particular thing in a particular manner alone, it is not open to anyone to adopt a contrary or different approach. ITAT observed that lower authorities have adjusted the operating costs of the assessee in allowing the capacity adjustment. Further ITAT elaborate the method to compute capacity utilization adjustment under TNMM.

Facts of the case:

• Assessee was established as an Indian company in 1990 as a wholly owned subsidiary of a Claas KGaA mbH, Germany.
• Until 31.8.2002, the assessee was known as Escorts Claas Ltd., with 60:40 joint venture between Escorts India Ltd., and Claas, Germany. Thereafter, the entire shareholding was acquired by Claas, Germany.
• The assessee’s main activity is manufacture and sale of harvester combines in India and export of harvester combines and engine harvester combines and engine related products, licensed by Claas Group.
• The assessee manufactures two types of harvester combines, namely, wheel based and track based.
• Certain international transactions were reported by the assessee including purchase of raw materials, sale of harvesters and spares, purchase of compute, payment for administrative and software support services, and receipt of market support services.
• The assessee applied the Transactional Net Margin Method (TNMM) as the most appropriate method with the Profit Level Indicator (PLI) of Operating Profit/Total Cost (OP/TC).
• All the international transactions were aggregated and a combined OP/TC was computed.
• The assessee chose three companies as comparable, namely, Eicher Motors, Force Motors and VST Tractors & Tillers.
• The assessee claimed that its adjusted OP/TC was at arm’s length.
• The TPO included M/s Punjab Tractors Ltd. (Segment), as one of the comparables, and excluded Eicher Motors and Force Motors from the list of comparables drawn by the assessee.
• TPO considered two companies as comparables, viz., VST Tractors & Tillers and Punjab Tractors Ltd. (Seg.) with their average OP/TC at 11.92%.
• Further AO observed that the assessee capitalized certain sum for development of a new product called TAF60.
• Till 30.9.2003, a sum of Rs.156 lac was capitalized and treated as capital work-in-progress. A further sum of Rs.28.32 lac was incurred on its development between 1.10.2003 to 31.3.2004.
• The assessee capitalized the entire sum and claimed deduction @ 25% of the same in the earlier years and in the year in question.
• The AO treated this amount as capital expenditure and did not allow any deduction. However CIT (A) allowed appeal of assessee on this issue and deleted Rs.37,03,000/- on account of deferred revenue expenditure.

Held by CIT (A):

CIT(A) upheld the inclusion of Punjab Tractors Ltd.(Seg.) and also directed to include Eicher Motors and Force Motors in the final set of comparables.

Inclusion/exclusion of companies in the list of comparables

(1) M/s Eicher Motors

• The assessee included this company in the list of comparables.
• The TPO observed that the most of the sales of this company were of tractors.
• Since the assessee was engaged in the business of manufacturing and selling harvester combines, the TPO held this company to be incomparable.
• CIT(A) noticed that the assessee was following TNMM as the most appropriate method. Since the harvester combines fall within the overall category of agricultural equipments, the CIT(A) held this company as comparable.
• CIT(A) has held a tractor manufacturer as comparable with a harvester combine manufacturer. Whereas a harvester combine is a machine that harvests green crops by combining three separate operations, namely, reaping, threshing and winnowing, a tractor is a vehicle used for drawing or pulling.
• In view of the inherent differences in the characteristics, usage and price of harvester combine and tractors, we are unable to countenance the view taken by the CIT(A) in treating M/s Eicher Motors as a good comparable.

(2) M/s Force Motors

• The facts of this company is very similar to M/s Eicher Motors and hence in the light of observation made in aforesaid company ITAT hold that M/s Force Motors cannot be considered as a good comparable.

Capacity utilization adjustment

Facts: