Brief of the Case: In the cited case, High Court inter-alia held that mere fact that an entity makes high/extremely high profits/losses does not, ipso facto, lead to its exclusion from the list of comparables for the purposes of determination of ALP. In such circumstances, an enquiry under Rule 10B(3) ought to be carried out, to determine as to whether the material differences between the assessee and the said entity can be eliminated. Unless such differences cannot be eliminated, the entity should be included as a comparable.
Facts of the Case: The assessee was a private limited company incorporated under the Companies Act, 1956 and was engaged in providing investment advisory services, which were reimbursed on a cost-plus mark-up basis. Ashish Dhawan and Kunal Shroff, in the concerned assessment year, were its two shareholders – holding shares in the assessee in the proportion of 2:l; they were also its full time employees. In A.Y.2008-09, the assessee entered into international transactions with associated enterprises (AEs) relating to advisory services and reimbursement of expenses incurred on behalf of AEs amounting to Rs.56,61,99,829/- and Rs.4,49,72,912/- respectively. For the purposes of determination of arm’s length price (ALP), the assessee used the Transactional Net Margin Method (TNMM). The assessee treated the transactions relating to reimbursement received by it from its associated enterprises on actual basis (i.e. without mark-up) at ALP as such since no value addition was done by it in relation to the said expenses. The assessee identified four entities which were engaged broadly in the same economic activities as in its case and identified as comparables. Based on the said four entities’ arm’s length analysis final average of operating profit between 2005-06 and 2007-08 came to be 4.04%.
On 30.09.2008, the assessee filed its return for A.Y.2008-09 declaring a total income of Rs.12,41,83,160. Its case was scrutinized by the AO who referred the matter to the Transfer Pricing Officer (“TPO”) under Section 92CA (3) of the Act. On 03.10.2011, the TPO passed an order recommending transfer pricing additions of Rs.20,93,34,155/- to the income of the Assessee. The TPO computed the Operating Margins of the four comparables above using single year data i.e. for F.Y.2007-08 and ignoring the data for two prior financial years i.e. 2005-06 and 2006-07 while determining the ALP. The TPO concluded that multiple year data for the assessee’s comparables could not be used but introduced two new comparables with abnormal business profits. The TPO also retained a comparable inspite of it showing abnormal growth in the assessment year under consideration and considered reimbursable expenses as part of operating expenses and corresponding reimbursement as part of operating revenue of the assessee for the purpose of determining the arm’s length price. The TPO held that the assessee had not furnished any detail as to how the data for the earlier years had an impact on the profits in the concerned assessment year of the assessee or the comparables. Based on the TPO’s report, the AO passed the assessment order on 21.12.2011, confirming the recommendations of the TPO. The AO also disallowed the bonus paid by the assessee to its shareholder employees – M/s.Ashish Dhawan (Rs.67,91,947) and Kunal Shroff (Rs.30,19,433) – under Section 36(l)(ii) of the IT Act.
The assessee filed its objections against the draft assessment order before the Dispute Resolution Panel (“DRP”). The DRP, by order dated 21.09.2012, confirmed the transfer pricing additions as-well-as the disallowance of the bonus made by the Respondent. Thereafter, on 19.10.2012, the AO completed the assessment under section 143(3) read with section 144C of the IT Act assessing the income of the assessee after sustaining the transfer pricing additions made by the TPO and disallowing the bonus paid to its shareholders.
The ITAT dismissed the Assessee’s appeal by its order dated 20.12.2013 and confirmed the additions made by the Respondent.
On aggrieved, the assessee preferred an appeal before the High Court. The questions framed for decision before the High Court that
a) Whether the proviso to Rule 10B(4) of the Income Tax Rules, 1962 will be applicable in case of fluctuations in the operating profit margins of comparable companies during the relevant financial year under question as compared to earlier years?
b) Whether comparables can be rejected on the ground that they have exceptionally high profit margins as compared to the assessee in transfer pricing analysis?
c) Whether factors like differential functional and risk profile coupled with high degree of volatility in operating profit margins is sufficient ground to reject comparables for transfer pricing analysis?
d) Whether disallowances can be made under Section 36(1)(ii) when the bonus paid to shareholders is not in the exact proportion of their shareholding and there is no avoidance of taxes?
Contention of the Assessee: The assessee submits that even if the ITAT’s ruling on the issue is accepted, Brescon and Keynote should be excluded from the list of comparables as the assessee’s risk profile is not similar to that of those two companies. They are risk-taking entities whereas the assessee operates on a cost plus model wherein a guaranteed return of 25% on costs is assured to it. The assessee further argues that its functional profile is significantly different from that of Keynote. Unlike the assessee, Keynote is involved in capital market activities, including lead managing IPOs, Rights Offers, Buybacks and Takeovers. Also, Keynote considers its activities to be a Merchant Banker as evidenced by its Director’s Report and Notes to Accounts of the concerned financial year. The assessee submits that in the audited financials of Keynote, there is no service-wise break-up of profits and therefore, the profitability of the advisory services segment (which may be considered similar to the services being rendered by the assessee) is not available to be compared with the assessee’s profitability. The assessee argues that Keynote’s profit margins have shown volatility over the years which could be attributed to abnormal business conditions and therefore Keynote should be rejected as a comparable altogether.
The assessee highlights that CIT(A) too had rejected Keynote in a preceding as well as succeeding assessment year i.e. A.Y.2007-08 and 2009-10. Further, Keynote has been excluded as a comparable by the DRP in a preceding assessment year i.e. A.Y 2006-07.
On the issue of disallowance of bonuses paid by the assessee to its two full-time shareholder employees, it is submitted that bonuses were paid to all its employees during the relevant financial year on the basis of their performance and qualifications. Both the individuals to whom the bonuses paid were disallowed have requisite qualifications, experience and expertise in the field of investment advisory services. Accordingly, keeping in view their experience, expertise and performance, the assessee had compensated them. The assessee submits that bonus under Section 36(1)(ii) of the Act is allowed as deduction if the same amount would not have been payable to the shareholders as profits or dividends if it had not been paid as bonus. The provision requires the sum paid as bonus to be exactly the same as to be payable as dividend in absence of the bonus for there to be a disallowance. The assessee submits that the bonus paid to the shareholder employees is not in the same proportion as their shareholding. It is also submitted that the basis for disallowance of bonus paid – that no dividend was declared by the assessee – is incorrect as it paid interim dividend amounting to Rs.5,47,47,000/- in the concerned assessment year. Thus, the bonus paid to the two shareholders was not in lieu of dividend and therefore, should be allowed as tax deductible expenditure.
Assessee argued that the ALP of an international transaction has to be determined by applying one of the methods provided in section 92-C (3) of the Act; it should be the most appropriate method and should also take into account prescribed factors. It was elaborated in Rule 10-B of the Rules, which contemplates adjustment on account of functional and other differences. He contended that adopting of any method ultimately envisages comparison of like functions, transactions and enterprises. Rule 10B(2)(a) provides that specific characteristic of services rendered by the two entities should be compared in order to treat the same as comparables for the purpose of transfer pricing analysis. Assessee also referred to the OECD guidelines and argued that accurate ALP determination is dependent on flexibility and sound exercise of discretion. Chapter III of the OECD guidelines was relied on to say that they recommend that where can it be determined that some uncontrolled transactions have a lesser degree of comparability than others, they should be eliminated. He also referred to Section A-5 of OECD guidelines on ‘selecting and rejecting potential comparables’ and pointed out that as per para 3.56, wherever uncontrolled transactions have a lesser degree of comparability than others, they should be eliminated. Assessee stated that similarly, Para 3.57 states that if the range of comparables includes a sizeable number of observations, statistical tools that take account of central tendency to narrow the range (e.g. the inter-quartile range or other percentiles); Para 3.59 suggests that where the application of the most appropriate method produces a range of figures, a substantial deviation among points in that range may indicate that the data used in establishing some of the points may not be as reliable as the data used to establish the other points in the range or that the deviation may result from features of the comparable data that require adjustments.
Assessee also relied on A.7.3 of the OECD guidelines dealing with “extreme results in the context of comparability considerations” to point out that extreme results might consist of losses or unusually high profits. These can affect the financial indicators that are looked at in the chosen method; some potential comparables have extreme results, further examination would be needed to probe such results. This important issue was overlooked by ITAT. Assessee relied on proviso to Rule 10-B (4) and stated that though the mandate of the law is ordinarily to rely upon comparables’ data for the current year, in certain circumstances, it is possible for the authorities to rely on previous years’ data restricted to two previous years. This is to eliminate any distorted picture which might be the consequence of adherence to the contemporaneous data, like in the present case.
It was argued that the DRP’s order for AY 2006-07 had accepted the assessee’s argument and excluded Keynote from the list of comparables, on the ground that the said concern had earned abnormally high or super profits. On that occasion, as compared with its previous year (A.Y 2005-06) profit level of 94%, the profit of the enterprise was 145%, registering a 51% increase over the previous year. This was considered to be too high to be allowed as a comparable. During the current year, the profit registered was 191%. In the circumstances, it was illogical and arbitrary for the revenue to have rejected the contention that data in respect of Keynote should have been excluded. It was also similarly argued that the ITAT fell into error in rejecting the assessee’s objection with respect to Brescon whose total turnover was over Rs.14 crore, of which the comparable business was only Rs.2 crore; the absence of any sectional data with regard to this company, meant that its activities were not comparable, on a fair application of Rule 10-B (2) and (3).
The assessee also argued that the rejection of previous years’ data, in the facts of the present case, was unwarranted. It was submitted that given that the comparables introduced by the TPO distorted the margins, the AO and DRP erred in determining the ALP on the basis of data for financial year 2007-08 only and ignoring the data for two prior financial years i.e. F.Y 2005-06 and F.Y 2006-07. It was submitted that the TPO had the option of reaching back to previous years’ data, since such power exists by virtue of proviso to Rule 10B (4). Assessee also relied on Part B.3, Paras 3.75 to 3.78 of OECD guidelines, in support of the submission.
Contention of the Revenue: The Revenue argued that five methods have been prescribed to determine ALP in relation to an international transaction and the comparability analysis requirements are method specific under Rule 10-B (1). Referring to the said Rule it was submitted that price charged or paid for the property transferred or service rendered in the comparable transaction is relevant in case of CUP and re-sale price method while the cost of production incurred in respect of property transferred or services provided is relevant for cost plus method. However, there is no mention of any property transferred or services provided in case of TNMM. They are provided for other methods. He contended that the relevant Rule thus makes it clear that specific characterization of the property transferred or services is not relevant for TNMM and this position is in conformity with the relevant OECD guidelines which suggest that broad comparability of functions should be done for TNMM.
Countering the submissions of the assessee, it was argued that neither the Act, nor the Rule contemplate exclusion of relevant transactions of like enterprises, in any manner other than what is prescribed. It was argued here that a comparable cannot be removed from consideration merely because it suffers loss; likewise, a unit or enterprise which enjoys higher profit (than the assessee or a significantly high profit in the industry) or even one making a so called “super profit” too cannot be eliminated. Generally, both loss making units and high profit making units cannot be removed from the list of comparables unless, such removal is statutorily permitted by Rule 10-B (2) or (3). Assessee also submitted that this is also evident from a reading of Rule 10-C. It was pointed out that Rule 10B (3) (ii) and Rule 10 C (2)(e) permitted adjustment to eliminate material defects of the difference between the assessee and comparables. Assessee argued that only those factors which result in material difference in the comparables of transactions as between the assessee and the unrelated transaction or the third party enterprise, have to be reasonably adjusted to avoid distortions under the said provisions. The step envisioned there had to be necessarily followed keeping in view the mandate “shall”.
It was also argued that the decision in Commissioner Of Income Tax vs Mentor Graphics (Noida) Pvt. Ltd (ITA 1114/2008, decided by this court on 04-04-2013) has held that OECD guidelines cannot be applied because there are specific provisions of Rule 10B (2) & (3) and the first proviso to Section 92C(2) which apply. There, it was held that having held that the comparables given by the assessee were to be accepted and those searched by the TPO were to be rejected, the only option then left to the ITAT was to derive the arithmetical mean of the profit level indicators of the comparables. It was submitted that accepting the theory of “abnormally high profits” as a ground for rejection of a comparable would lead to vagueness and confusion because what constitutes abnormally high has nowhere been spelt out in the Act or rules. On the other hand, the margin of variation permitted is ± 3% (proviso to Section 92C (2), reduced from the 5% margin that existed earlier). Introduction of any other variation not based in law would not be justified.
Held by ITAT: ITAT dismissed the Assessee’s appeal by its order dated 20.12.2013 and confirmed the additions made by the Respondent.
Held by High Court:
After examining the facts and circumstances, the Delhi High Court held that
a) The mere fact that an entity makes high/extremely high profits/losses does not, ipso facto, lead to its exclusion from the list of comparables for the purposes of determination of ALP. In such circumstances, an enquiry under Rule 10B(3) ought to be carried out, to determine as to whether the material differences between the assessee and the said entity can be eliminated unless such differences cannot be eliminated, the entity should be included as a comparable.
b) While determining the comparability of transactions, multiple year data can only be included in the manner provided in Rule 10B(4). As a general rule, it is not open to the assessee to rely upon previous year’s data.
c) As regards Khandwala Securities and Brescon, the matter is remitted to the DRP to carry out the analysis under Rule 10B(3) and determine whether the material differences arising out of their exceptionally high profits can be eliminated. If not, the said entities cannot be included as comparables. For Keynote, firstly, enquiry is to be carried out by the DRP, preceding the analysis under Rule 10B(3), as to its functional similarity with the assessee; thereafter, the exercise of determining if there are material differences on account of exceptionally high profits which are capable of elimination has to be carried out.
d) The deduction claimed by the assessee under Section 36(1)(ii) of the Act, in respect of the bonuses paid to its shareholder-employees is allowed.
The appeal was accordingly partly allowed.