The Delhi bench of the Income-tax Appellate Tribunal [“The Tribunal”] recently pronounced its ruling in the case of Haworth (India) Private Limited Vs. DCIT [ITA NO. 5341/DEL/2010], wherein it upheld Revenue’s contention that arm’s length price can be determined under transactional net margin method [“TNMM”] even with one comparable company. Besides, the decision also deals with several other important aspects of the manner of application of TNMM, viz. method of making adjustments to the results, use of current year data, benefit of +/- 5% range and functional comparability. Facts
The Taxpayer is a wholly-owned subsidiary of Haworth Inc. and is engaged in the business of manufacture and sale of Haworth branded furniture using raw material imported from its associated enterprises [“the AEs”]. It also renders marketing and installation support services to its AEs.
During the relevant assessment year, the Taxpayer created two segments for the purpose of bench marking the aforesaid transactions, namely manufacturing segment and marketing support services [“MSS”] segment.
For manufacturing segment, TNMM was adopted as the most appropriate method with operating profit on sales (“OP/Sales”) as profit level indicator [“PLI”]. Since the Taxpayer’s PLI of 13.50% (after making adjustment on account of capacity utilization and pre-operative expenses) was higher than com parables’ PLI of 8.45%, it was concluded that the arm’s length principle was satisfied.
For MSS segment also TNMM was adopted as the most appropriate method with operating profit on costs (“OP/TC”) as the relevant PLI. The Taxpayer’s PLI was computed at 1.35% as against com parables’ PLI of 3.15%. The transactions were inferred to meet the arm’s length principle by the application of +/- 5% range permitted in law.
During the course of assessment proceedings, the transfer pricing officer [“TPO”] held as under :
- Regarding the manufacturing segment, the Taxpayer had claimed adjustment for capacity utilization and preoperative expenditure since it had commenced its manufacturing activity in December 2005 and had achieved a capacity utilization of 30.58% as against com parables’ average utilization of 70%. The same was rejected by the TPO on account of the fact that the statutory auditors did not consider any expenses to be pre-operative and no pre-operative expenses appeared in the P&L Account. The TPO further observed that capacity utilization adjustment was claimed in respect of such expenses which had been charged to P&L Account only for the post-production period. Further, no reliable evidence was available to examine the capacity utilization of the com parables.
- Regarding the MSS segment, the TPO observed that the Taxpayer had revised its return of income and had suo-motu claimed dis allowance of certain expenditure, pursuant to which, it recomputed its PLI at 9.63% (as against original PLI of 1.13%). However, the TPO did not permit such re-computation and considered such disallowed expenses as operating cost.
- Further, three comparable companies were rejected due to non-availability of current-year data and one more comparable Alfred Herbert India Limited [“Alfred Herbert”] was excluded on account of functional dissimilarity and non-availability of segmental information.
- Consequently, an upward adjustment was made to the total income of the Taxpayer without allowing the benefit of +/-5% range since such benefit was available only in case of more than one arm’s length price
The Taxpayer approached the Dispute Resolution Panel [“DRP”] contesting the adjustments. The DRP upheld the transfer pricing adjustments. It also remarked that the aforesaid disallowed expenses could not be considered while computing the Taxpayer’s PLI since the Taxpayer had itself given up its claim regarding such expenditure and further, it was not clear whether such expenses actually formed a part of operating cost for TP analysis.
Ruling of the Tribunal
On appeal, the Tribunal held as under:
- The Tribunal noted that such disallowed expenses were in the nature of commission paid. It also noted that since commission income formed a substantial part of Taxpayer’s total income, therefore commission expense would also have been claimed as operating expenses. Therefore, once the return was revised claiming dis allowance of such expenses, they should also be excluded from operating cost.
- The Tribunal concurred with Revenue’s contention to use only current-year data and stated that proviso to Rule 10B(4) can be used only in those circumstances where the Taxpayer produces documentary evidence to demonstrate that prior years’ data had an influence on the determination of transfer price
- The Tribunal concurred with Revenue’s contention regarding acceptance of single comparable and remarked that the mere fact that only one comparable is left cannot constitute a valid reason to carry out or rely on a fresh search
- The Tribunal concurred with Revenue’s rejection of Alfred Herbert and concluded that a company majorly dealing in other segments cannot be accepted as functionally comparable
- Operational expenses connote expenses which are incurred to earn operational income. Since the expenses claimed as pre-commencement expenses had nexus with the Revenue earned by the Taxpayer, therefore they cannot be excluded from operating cost merely because such expenses have been incurred prior in time to occurrence of revenue. Thus, the Taxpayer’s contention was rejected
- There cannot be any deviation in the net profit shown in the books of account and adjustment can be made to the results of the com parables only if it is reasonably accurate. Further, it is the legal obligation of the Taxpayer to keep and maintain information and documents in respect of any assumption made by it which has critically affected the determination of arm’s length price. Since the Taxpayer could not furnish any credible information pertaining to capacity utilization of com parables, therefore the said adjustment was not permitted to the Taxpayer
- The Tribunal observed that the DRP, in its order, did not discuss the Taxpayer’s objection regarding incorrect computation of arm’s length price and accordingly, the matter was restored to the file of DRP
- The benefit of +/- 5% is not available in cases where only one arm’s length price is determined and therefore, the same was not allowed in MSS segment, but allowed for manufacturing segment
Conclusion – This decision underscores the importance certain established principles (like that of use of single year data, onus of maintaining documentation and the benefit of 5% margin) besides laying down categorically the permissibility of use of a single comparable for a TNMM analysis.