Provision for doubtful and bad debts to be considered as operating expense in TP calculations

Evolving Systems Networks India Pvt. Ltd. Vs DCIT (ITAT Bangalore)

The only other ground pressed was with regard to the action of the TPO in treating provision for bad and doubtful debts as part of non  operating expense while computing operating margin of comparables. 

Karnataka High Court has also taken a view in the case of Business Process Outsourcing India Pvt. Ltd., (supra) that provision for bad and doubtful debts should be taken as operating expenses while computing profit level indicator of the comparable companies. In the light of the aforesaid decisions which have been cited at the time of hearing of the appeal, we are of the view that the claim of the assessee deserves to be accepted

FULL TEXT OF THE ORDER OF ITAT BANGALORE

This is a Miscellaneous Petition (MP) filed by the assessee under section 254(2) of the Income Tax Act, 1961 (hereinafter called ‘the Act’) praying that there are apparent mistakes in the order of the Tribunal which requires to be rectified.

2. The issue that was decided by the Tribunal in the aforesaid appeal was the correctness of the determination of ALP in respect of international transaction of rendering software development services by the assessee to its wholly owned holding company which was Associated Enterprise (AE) in terms of section 92 of the Act. One of the issues which was raised by the assessee in ground No.4(h) was the issue with regard to treating provision for bad and doubtful debts as non-operating in nature while computing the operating margin of the comparables. Ground No.4(h) reads as follows:

4(h) treating provision for bad and doubtful debts as non-operating in nature while computing the operating margin of the comparables.

3. In the impugned order, the Tribunal has held as follows:

“11. The only other ground pressed was with regard to the action of the TPO in treating provision for bad and doubtful debts as part of non  operating expense while computing operating margin of comparables.  On this issue, which is raised for the first time, we do not find any  grounds raised before the lower authorities and hence this ground does  not arise out of the order of the AO and hence dismissed. No other grounds raised in the grounds of appeal as well as the additional grounds were pressed for adjudication as in the opinion of the counsel for the learned counsel for the Assessee, those grounds would become academic.”

4. In this MP, the Assessee has submitted that the Tribunal was not correct in dismissing the ground with respect to the treatment of provision for doubtful and bad debts as non operating in nature by stating that the same was not raised with the lower authority and did not arise from the order of the AO. In this regard, it has been submitted that on the grounds on the treatment of provision for doubtful and bad debts as operating in nature was raised before the Transfer Pricing Officer (TPO) and the Dispute Resolution Panel (DRP). A reference has been made to the following pages in the paper book reference evidencing the issue raised and argued before the revenue authorities:

It has been submitted that the observations of the tribunal in the order that the grounds relating to treatment of provisions for doubtful debts was not raised before any lower authority or appellate forum is incorrect and thus constitutes a mistake apparent from record liable to rectification as specified under section 254(2) of the Act. It has also been submitted that if the ground on provision for bad and doubtful debts as constituting operating cost is accepted, the results of the Assessee will be at arms-length. The issue whether negative working capital adjustment should be made would then become academic.

5. The learned Counsel for the assessee reiterated the facts stated in the MP referred above. We have considered the submissions and are of the view that there is apparent mistake in the order of the Tribunal in as much as in para 2.9 at 11 of the DRP’s order, the ground with regard to not considering provision for bad and doubtful debts as operating expenses as claimed by the assessee has been rejected by the DRP and therefore the issue with regard to not considering provision for bad and doubtful debts as operating expenses was very much decided by the lower authorities and therefore the Tribunal ought to have adjudicated ground No.4h of the grounds of appeal raised by the assessee in its appeal. We therefore proceed to decide Gr.No.4 (h)

6. As far as the merits of ground No.4(h) is concerned, the DRP dealt with the issue in the following manner:

“2.9 Ground of Objection No. 9:

The learned TPO and learned AO has erred, in law and in facts, by considering provision for bad and doubtful debts as non-operating expenses.

Having considered the submissions, this Panel has been consistently holding that provisions are not an ascertained liability which is not allowable for purpose of computation of business profit under the IT Act. We are also of the view that the provision for bad & doubtful debts is not made in all the cases. There is no rationale to consider such provision as operating in nature. Even otherwise, for the comparability analysis, such provisions are excluded from the tested parties as well as the comparable, the error in the margins of the relevant year are taken care of. This view of the Panel finds support from several decisions ofthe Hon’ble ITAT, for example in the case of M/s Telcordia Technologies India Pvt. Limited 22 taxmann.com 96/ 137 ITD 1 (Mum)is squarely applicable to the assessee case in which it was decided that the provision for doubtful debt cannot form part of operating cost. Further, In the case of Thyssen Krupp Industries India Pvt Ltd, [2013] 33 taxmann.com 107 the Hon’ble Mumbai Tribunal held that provision for doubtful debts is to be considered as non-operating in nature because it is only a provision. While working out the operating profit, only items of receipts and expenditure, which have direct relation for determining the profit have to be taken into account. In the case of Four Soft Ltd. v. Dy. CIT [2011] 142 TTJ 358/[2012] 16 ITR (Trib.) 73 (Hyd.), it was held that for computing the net margin of the assessee for the purposes of transfer pricing, only the cost related to the transaction with the AEs has to be considered and that bad debts/reimbursements have to be excluded. Thus the expenses excluded by the TPO were in the nature of non-operating expenses. Therefore, we do not find any infirmity in the approach of the TPO. Hence, the objection is not found acceptable. Accordingly, we do not find merit in the plea that the margin computation of M/s CG VAK, ICRA Techno Analytics Ltd, L&T Info tech, Persistent Systems & Tech Mahindra are erroneous.”

7. Learned Counsel for the assessee brought to our notice the decision of the ITAT, Bengaluru Bench, in the case of Maxim India Integrated Circuit Design Pvt. Ltd., Vs. DCIT in IT(TP)A No.1573/Bang/2017 order dated 02.11.2020 wherein this Tribunal dealt with identical ground of appeal after considering the decision cited in the order of the learned DRP as follows:

“13. The next contention of the assessee is that the TPO has not considered Provision for bad and doubtful debts as an operating expenditure. The Ld A.R submitted that the co-ordinate bench has held this expenditure as operational in nature in the case of Brocade Communications Systems (P) Ltd vs. DCIT (2020)(117 taxmann.com 439)(Bang.). On the contrary, the Ld D.R submitted that the provision for bad and doubtful debts is not an ascertained liability and hence it cannot be considered to be operational in nature. He placed his reliance on the decision rendered by Mumbai bench of Tribunal in the case of Telcordia Technologies India P Ltd (22 taxmann.com 96/137 ITO 1) and Thyssen Krupp Industries Pvt Ltd (2013)(33 taxmann.com 107).

14. We heard the parties on this issue and perused the record. We notice that an identical issue has been examined by the co- ordinate bench in the case of Brocade Communications Systems (P) Ltd (supra) and it was decided as under:-

“47. In Ground No. 10 the assessee pointed out to the mistakes in computation of PLI. It was submitted that the TPO has considered provision for doubtful debts and provision for doubtful advances are non-operating in nature and the action was upheld by the DRP. In this regard it was submitted that provision for doubtful debts is a provision which is to be made as a part of the operating activities of business governed by the principles of prudence, and therefore it is not correct to contend that the same is non-operating in nature. Reliance in this regard is placed on the decision of the Delhi Bench of the Tribunal in the case of Rolls-Royce India (P.) Ltd. v. DCIT [2016] 69 taxmann.com 209 (Delhi – Trib.). Therefore it was submitted that the aforesaid items are to be treated as being operating in nature.

48. The ld. DR relied on the order of the DRP.

49. We are of the view that in the light of the decision of the Tribunal in the case of Rolls-Royce India (P.) Ltd. (supra), the PLI should directed to be reworked by considering the provision for doubtful debts as operating expenditure. We hold and direct accordingly.”

In the case of Rolls-Royce India (P) Ltd (supra), the nature of “Provision for doubtful debts was discussed as under:-

“51. As regards provision for doubtful debts, ld. counsel submitted that provision for doubtful debts are a part of the operating activities of a business. The accounting standards issued by the ICAI require that accounting policies must be governed by the principles of “prudence”. Provisions should be made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only the basic estimate in the light of available information. Para 6 of Accounting Standard-l defines accrual as the assumption that revenues and costs are accrued, i.e., recognized as they are earned or incurred and recorded in the financial statements of the period to which they relate.

52. Thus, going with the abovementioned facts and statutory provisions, when the making of provisions is very much in the interest of business to show the true and fair view and statutorily required, it cannot be said that such provisions are of non-operating nature. Such provisions are made to comply with the requirements of statute.

53. The learned TPO treated provision for doubtful debts as non-operating referring to the Safe Harbour Rules notified by CBDT, which are not applicable for the year under consideration as mentioned above.

54. CIT(DR) relied on the order of TPO.

55. As regards the treatment of provision of doubtful debts also, we find that the reasoning given by ld. TPO cannot be accepted because he has primarily relied on safe harbor rule for treating this as non-operating expenditure. We find considerable force in the submission of ld. counsel for the assessee, considered earlier, that provision for doubtful debts is a provision which is to be made as a part of the operating activities of business governed by the principles of prudence. We, accordingly, direct that this provision be treated as part of operating expenditure and treatment be made accordingly, because, in any view of the matter, the safe harbor rule is not applicable for the current year under consideration. In the result, this ground is allowed.”

15. Before us, the Ld D.R placed his reliance on the decision rendered by Mumbai bench of Tribunal in the case of Thyssen Krupp Industries Ltd (supra). We notice that the assessee has claimed that the Provision for doubtful debts as non-operating in nature, which was not accepted by the TPO. The Tribunal accepted the submission of the assessee and accordingly it has held that it is a non-operating in nature. Thus, we notice that the above said decision has been rendered by the Mumbai bench of Tribunal in a different context. In the case of Telcordia Technologies India P Ltd, the Tribunal has made following observations in respect of Provision for doubtful debts, while considering the company named M/s R Systems International Ltd:-

“While working out the operating profit, only items of receipts and expenditure, which have direct relation for determining the profit has to be taken into account. Operating profit has to be seen in a comparable transaction under comparable circumstances. The profit level indicators are derived from uncontrolled party engaged in similar business activity under similar circumstances which is the measure of arm’s length result. If the assessee’s business transactions do not have accretion of doubtful debts and doubtful advances, such an adjustment has to be made in the comparability analysis of the comparable party to determine the arms length price. Thus, both these expenses have been rightly excluded by the TPO to work out the operating profit of the comparable party and accordingly the operating profit ratio of the said entity has been rightly taken by the TPO.”

Thus, we notice that the above said decision was also rendered in a different context. However, there should not be any dispute that if the provision for doubtful debts is taken as operating expenses in the hands of the assessee, then the said expenditure has to be taken so in the case of comparable companies also.

16. Accordingly, following the decision rendered by the co-ordinate bench in the case of Brocade Systems (P) Ltd (supra) and Rolls Royce India (P) Ltd (supra), we direct the AO/TPO to consider Provision for doubtful debts as an operating expense.”

8. Learned Counsel brought to our notice the decision of the Tribunal rendered in the case of ACI Worldwide Solutions Pvt. Ltd., Vs. DCIT in IT(TP)A No.1893/Bang/2017 order dated 27.09.2019 wherein this Tribunal decided identical issue in favour of the assessee by following the decision of the Hon’ble Karnataka High Court in the case of Pr.CIT Vs. Business Process Outsourcing India Pvt. Ltd., (2018) taxcorp (DT) 73195 (HC Karnataka). The following were the relevant observations of the Tribunal:

“8. As far as the exclusion of provision of bad and doubtful debts from the operating cost of the comparable companies is concerned, the learned Counsel for the assessee brought to our notice that while considering the international transaction in the distribution segment, the TPO has himself considered provision for bad and doubtful debts as part of the operating expenditure and by the same logic he should have treated provision for bad and doubtful debts as part of the operating cost in the hands of the comparable companies also. As far as the software development segment of the assessee is concerned, there is no provision for bad and doubtful debts. The learned Counsel for the assessee filed before us copy of the decision of the Hon’ble Karnataka High Court in the case of Principal CIT Vs. Business Process Outsourcing India Pvt. Ltd., (2018) taxcorp (DT) 73195 (HC Karnataka) wherein in an appeal against the order of the Tribunal holding that provision for bad and doubtful debts should be considered as part of the operating expenditure, the Hon’ble High Court confirmed the order of the Tribunal and dismissed the appeal of the Revenue as one not giving rise to any substantial question of law.

9. In the light of the aforesaid decision, we are of the view that provision for bad and doubtful debts should be treated as operating expense while computing the PLI OP/OC of the comparable companies which ultimately remains for comparison. We hold and direct accordingly. “

9. Learned DR relied on the order of the DRP.

10. We have given a very careful consideration to the rival submissions. We find that the DRP in rejecting the plea of the assessee has placed reliance on the decision of Mumbai Bench of the Tribunal in the case of M/s. Telcordia Technologies India Pvt. Ltd., (supra) and the decision in the cae of Thyssen Krupp Industries India Pvt. Ltd., (supra). Both these decisions have been considered in the Bengaluru Bench of the Tribunal rendered in the case of Maxim India Integrated Circuit Design Pvt. Ltd., (supra). The Tribunal, after noticing the fact that in the decision cited in the order of the DRP, the facts were different and would result in the same effect if the claim of the assessee is accepted. Besides the above, the Karnataka High Court has also taken a view in the case of Business Process Outsourcing India Pvt. Ltd., (supra) that provision for bad and doubtful debts should be taken as operating expenses while computing profit level indicator of the comparable companies. In the light of the aforesaid decisions which have been cited at the time of hearing of the appeal, we are of the view that the claim of the assessee deserves to be accepted. Accordingly, ground No.4(h) raised by the assessee has to be allowed and is hereby allowed.

11. Consequent to the aforesaid conclusion, portion of para 11 of the order of the Tribunal dated 24.06.2021 given in bold letters in the earlier part of this order will stand substituted by the observations made in Paragraph 6 to 10 of this order as paragraph 11.1 to 11.5 and the remaining part of paragraph 11 will stand substituted as paragraph 11.6.

12. In the result, the miscellaneous petition is allowed to the extent indicated above.

Pronounced in the open court on the date mentioned on the caption page.