Demag Cranes & Components (India) Pvt. Limited Vs. DCIT (ITAT Pune)- provisions of 10B(1)(e)(iii) of the Income tax Rules, 1962, which provides for the adjustments in the context of TNMM. From the above, it is explicitly clear that the for the arriving at the arm’s length price (ALP) as per TNMM, the net profit margin arising out of the comparable uncontrolled transactions is adjusted to take into account differences, if any between the (i) international transactions and filtered comparables of uncontrolled transactions or enterprises entering into such transactions, which could materially affect the amount of the net profit margin in the open market. It is a fact the differences, if any mentioned in the said sub-clause (iii) are not specified in the Act. However, as evident from the above extract of the provisions, they provide for certain guidelines i.e. any differences, which could materially affect the amount of net profit margin fall in the scope of adjustments. Further, we may also take help of the available material in the form of the I T rules, explanation-memoranda, commentaries, OECD guidelines, various judicial decisions etc. In the light of the above scope of the rule 10B and the effects of the WC on the price1profit margin, we shall now discuss the existing law on hand on the issue of adjustments on accounts of the WC related differences between the tested party and the benchmarked comparable.
IN THE INCOME TAX APPELLATE TRIBUNAL, Pune
ITA No. 120/PN/2011 – Assessment Year: 2006- 07
Demag Cranes & Components (India) Pvt. Limited
Date of pronouncement: 04.01.2012
Per Shri D. Karunakara Rao, Accountant Member:-
This appeal is preferred by the assessee against the order of the CIT(A). There are 15 grounds with corresponding sub-grounds raised in this appeal.
2. Briefly the heading of the grounds read as follows.
7. Further also, the AO proposed to make addition on account of the disallowance of provision of warranty to the extent of Rs 2,26,20,069/- and such additions were in earlier years too. Finally, the AO proposed to determine the assessed income at Rs 9,88,12,740/- against the returned income of Rs 6,40,30,984/- and finalized the draft assessment order.
Proceedings before the DRP:
8. These issues traveled to the Dispute Resolution Panel – DRP, Pune as per the provisions of the Act and the assessee filed various objections opposing the above said three adjustments, namely adjustments to manufacturing and trading segments and disallowance on account of warranty provisions. The assessee’s written objections relating to adjustments to manufacturing and trading segments are briefly as under:
> Non consideration of the compatibility analysis as documented in the TP report.
> Rejecting the aggregation of international transactions entered into by the assessee pertaining to manufacturing and trading activities.
> Incorrect determination of margin of manufacturing activity
> Non-grant of working capital adjustment
> Use of single year data pertaining only to F.Y.. 2005-06
> Use of financial information of the com parables pertaining to F.Y. 2005- 06 which was not available at the time of preparing the documentation report.
> Non-inclusion of high sea sales and services income for the purpose of computing appellant’s margin for manufacturing activity
> Not granting adjustment on account of provision for warranty claims and expenses on account of import raw materials, components and spares attributable for lower margins of assessee in respect of manufacturing activity.
> Using Resale price method as the most appropriate method for analyzing the arms length nature of the transaction of export of components and spares
> Computation of transfer pricing adjustment from the arithmetic mean of the arm’s length price instead of lower 5% arithmetic mean of arm’s length price.
> Incorrect computation of transfer pricing adjustment to the manufacturing activity.
9. At the end of the proceedings before the DRP, the adjustments to manufacturing segment were upheld. The other directions of the DRP, relating to (i) dis allowance of warranty provision and (ii) adjustments to the international transactions of the trading segment, are given as under.
(a) On the adjustment of Rs 2,28,20,059/- on account of Provision of Warranty: Vide the paragraphs 3.3.2, DRP directed the AO to verify the actual expenditure on warranty expenses incurred during the year and allow the same on actual-basis and accordingly, the provisions as well as the reversals should not be allowed as a deduction or taxed respectively.
(b) On the adjustment of Rs 8,36,293/- relating to trading segment, as per the assessee’s claim, the DRP upheld the assessee’s views that the Resale Profit Method – RPM is not an appropriate method for bench marking purpose and the directed the AO to compute the arm’s length nature of the adjustments by comparing the net margins earned by the assessee from its sale to third parties (17.74%) as against the margin earned by the assessee on its sales to the AEs (4.65%). Otherwise, the TPO adopted gross margin. Thus, the issue was remanded to the files of the AO for an appropriate re computation. However, in view of the DRP’s silence on the need for using the TNMM and also clear direction to consider the variance of 13.42%, the AO complied with the direction of the DRP scrupulously.
Proceedings before the ITAT:
10. Aggrieved with the (i) above directions of the DRP; (ii) the findings of the AO1TPO; and (iii) non consideration of the arguments of the assessee, the present appeal is filed before us with the grounds summarized above in the language of the assessee. During the proceedings before us, the assessee was represented by Shri M.P. Lohia, Shri Anil B. Jain & Shri Rajendra Agiwal and the revenue is represented by Shri S.K. Singh CIT-DR & Shri Tejendra Singh CIT. The grounds are categorized into two categories (i) those which should be disposed as NOT PRESSED or ACADEMIC ones and (ii) the ones that requires adjudication. Firstly, we shall take up the ones categorized as (i) above.(i) GROUND TOBE DISMISSED AS NOT PRESSED OR ACADEMIC:
11. Shri M.P. Lohia took the lead and stated that the grounds raised in the appeal essentially revolve around the above three adjustments made by the revenue. The issues in the grounds relate to both academic as well as on merits of the additions. As per the assessee, the AO1PTO1DRP denied various claims, which are legally due to the assessee. Sri Lohia dutifully explained the need for adopting (i) the multiyear data as existed at the time of compliance to the guidelines; (ii) approach of aggregation of international transactions entered into by the assessee pertaining to both manufacturing and trading activities. He also questioned the order of the DRP in not granting adjustment on account of (a) working capital; and (b) import cost. Ld Counsel raised other issues and they are: (i) non granting of the standard deduction as per the proviso to section 92C(2) of the Act; (ii) rejection of claims on use of multiyear data and adoption of contemporaneous data ie as existed at the time of assessment; (iii) merits of adjustments made by the revenue on accounts of both manufacturing and trading activities. (iv) other issues in the grounds number 15raised in appeal. 12. Summarizing the said grounds, Sri Lohia mentioned that the ground 1 is general and gets covered by the decision of the Tribunal on the other specific grounds of the appeal. Accordingly, the same may be dismissed as general in nature. We find the request of the AR is n order. Accordingly, ground 1 is dismissed as general.
15. The issue on ground no.8 relates to international transaction pertaining to export of components and spares using and the decision of the revenue authorities to resort to resale price method (RPM) while TNM method is an applicable one to the impugned international transactions. Ld counsel mentioned that the difference in figures between the TNMM method and the resale price method is small and seeks direction of the Tribunal to the AO. On the other hand, the Ld. D.R. for the revenue also mentioned that the revenue will take necessary action to correct the mistake in this regard in an appropriate manner. We have heard the parties and perused the facts and the proceedings in the matter and find that the DRP has erred in not granting non-contradicting directions to the AO. As discussed above, the DRP has not approved the RPM as an appropriate method to the sale1trading activities involving the AEs or third parties for arriving at the arm’s length margins. On the other hand, it recommended the net margins analysis of AEs and the third parties, which is essential ingredient of the TNMM method. If the TNMM with the due adjustments is applied, the addition is meager. Considering the promise of the Ld DR, we proceed to remit the issue to the AO for deciding the issue after applying the TNMM in its true spirit. Accordingly, ground no.8 is allowed.
16. Regarding the Grounds 13 to 15 relating to the issue of short grant of TDS1SA and charging of interest u1s 234B and 234C of the Act, Ld Counsel mentioned that they are either consequential in nature or covered issues as the case may be, in favour of the assessee. In any case they are settled issues in faour of the assessee. Considering the settled nature of these issues, we direct the AO to grant necessary relief. Accordingly, ground nos.13 to 15 are remitted to the files of the AO for recomputation after hearing the assessee.
(ii) GROUNDS FOR ADJUDICATION:
17. That leaves ground 4(a) relating to working capital related adjustments, ground 4(b) relating to import expenses related adjustments, ground 9 relating to applicability of proviso to section 92C(2) of the Act and ground 10 relating to incorrect computation of TP adjustments linking the adjustments to the gross manufacturing segment sales of Rs 23.32 cr (rounded off) instead of the proportionate sales, which is 40 of the total sales, relatable only to the imports of raw materials, components and spares etc. Balance of the 60% of the sale relates to the indigenously acquired purchases. Issue wise adjudication is given in the succeeding paragraphs of this order.
Ground 4(a) – Working Capital Adjustment:
18. We will take up the issue relating to the ‘working capital’ raised in sub ground 4(a) of the appeal. At the outset, Sri Lohia mentioned that in principle, the TP guidelines advocate in favour of making of adjustments to the unadjusted margins of the tested parties and six comparable on account of ‘working capital’. Referring to the contents of para 7.3.1 of the ‘Directions of the DRP’ dated 14.9.2010, given u1s 144C(5) of the Act, Ld Counsel mentioned that the DRP merely and passively relied on the ‘detailed reasoning for adopting the PLI of the proposed set of com parables at 7.18%’. DRP failed to pass directions on this issue of working capital related adjustments to be made to the martins of the tested parties. Sri Lohia demonstrated the fact of raising of the issue before the DRP and non-adjudication of the ground by the DRP and took us through the contents of the impugned orders1directions. On this issue of requirement of making of the working capital adjustments to the margins of the comparable, Ld Counsel for the assessee mentioned that the AO1DRP1TPO have erred in not following the TP guidelines on one side and the existing decisions of the Tribunal directly on this issue. Referring to the decision of the Tribunal in the case of Mentor Graphics (Noida) (P) Ltd. 109 ITD 101, Ld Counsel mentioned that the ‘final set of com parables may need to eliminate differences by making adjustments for the following: (a) Working capital……..” (para 27). Further, referring to the decision of Pune bench in the case of E-gain Communication P Ltd reported in 118ITD 243, Ld Counsel mentioned that when TNMM is applied to a case, ‘the differences which are likely to materially affect the price, cost charged or paid in, or the profit in the open market are to be taken into consideration with the idea to make reasonable and accurate adjustment to eliminate the differences having material effect.’ If these differences are not eliminated or removed, the comparison becomes unsound and unreliable. Further also, the decision of the Delhi Bench in the case of Sony India P Ltd (114 ITD 448) was cited for the proposition that deduction of 20% is allowable for various differences on account of intangibles, R&D, risk factors, working capital, etc. Referring to contents of the para 132 and 137 of the said decision, Sri Lohia stated that in that case the CIT(A) allowed adjustment to the extent of 10% against the 20% allowed by the TPO. Tribunal upheld the views of the TPO in the mater. Further also, referring to para 13.2 of the order of the Tribunal, Bangalore Bench, in the case of TNT India P Ltd, Ld Counsel mentioned that ‘similarly, the working capital adjustments also have to be considered while arriving at the operating net margins.
Written submissions of the DR
19. Per contra, Sri S K Singh CIT DR and Shri Tejendra Singh CIT relied on the written submission sent by the present Sri Sajnay Singh Addl DIT (TP)-1, Pune. Briefly, the revenue’s contentions include (i) assessee did not make the claim for adjustment on account of ‘working capital’; (ii) any adjustment has to be allowed in accordance with the provisions of Rule 10B(1)(e) relating to TNMM and relied on sub-clause (iii) for the proposition that the assessee failed to demonstrate that the impugned ‘working capital’ adjustment materially affect the price1cost1profit of relevant international transactions in the open market. (iv) as per the revenue, in the absence any definition, the ‘net profit margin’ normally mean the profit before tax (PBT); (v) there is elaboration on the expression ‘difference’ used in the said sub clause (iii) and detailed the fact that the six comparable are filtered by the assessee himself on being satisfied about their fulfillment of the comparability on the functionality filter. Assessee never demonstrated the existence of difference on account of working capital before the TPO; (vi) Further, the revenue holds that the PLI to be adopted in the TNMM should be real and not notional one for bench marking the arm’s length margins.
Decision of the Tribunal on Working Capital Adjustment:
20. We heard the parties on this issue and examined the facts of the case in the light of the documents available before us. It is a fact that there is no dispute on the applicability of the TNMM for computing Arm’s Length Margin.
21. The undisputed areas between the parties include (i) there is no issue on the six comparable identified and supplied for the bench marking of the Arm’s Length Margin; and (ii) there is no dispute on the requirement of elimination of the differences, if any for arriving at the credible ALP realized by the enterprise or by the unrelated enterprise from a comparable uncontrolled transactions in the bench marking exercises. However, we find there is dispute on (i) if the ‘working capital’ constitutes a ‘difference, if any between the international transactions and the comparable uncontrolled transactions of between the enterprises entering into such transactions,’ as mentioned in sub-clause (iii) of clause (e) of Rule 1OB(1) of the Income Tax Rules, 1962; and (ii) if the answer to first issue at (i) above is positive, next issue relates to if the said difference ‘could materially affect’ the amount of net profit margin of relevant transactions in the open market. We shall take up the first dispute mentioned above ie If the ‘working capital’ in instant case constitutes a ‘difference, if any.
(i) If the ‘working capital’ (WC) constitutes a ‘difference, if any:
22. For adjudication of the above, in our opinion, there is need for explaining the relevant provisions of Rule 1OB of the income tax Rules 1962, meaning and impact of the WC on the pricing or margin or profiting of the transactions, the decided cases on this issue of WC. We shall take up the meaning and relevance of Working Capital.(A) Meaning of WC: Working capital is a financial metric which represents operating liquidity available to a business M . Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. Current assets and current liabilities include three accounts which are of special importance. They are: accounts receivable (current asset) inventory (current assets), and1accounts payable (current liability). These accounts represent the areas of the business where managers have the most direct impact. (Source: www. wikipedia. com)
(B) Effect of working capital on the Transactional pricing in turn on the Prices1 Net Profit Margin of the transactions: TNMM requires the comparing the operating profit relative to an appropriate base ie PLI of the tested party ie the controlled enterprise or transactions. Appropriate base1PLIs in controlled transaction in the TNMM are cost, sales and assets. PLI includes (i) rate of returns on capital employed ie operating profit to operating expenses (ii) financial ratios —relationships between profit and costs1sales revenue (iii) other if they provide reliable measures of the income. Therefore, the question is if the Net working capital, ie current assets (accounts receivables + inventory) minus current liabilities (accounts payable), effects the pricing and therefore the net martins and therefore does it constitutes the ‘difference’ for the purpose of the provisions of sub clause (iii) of 1OB(1)(e). The answer is affirmative. The reasons are that the ‘accounts receivable’ is generally with reference to the sundry debtors and the ‘inventory’ refers to the available raw materials or finished products or the stocks in trade. All these accounts traces their origin to the working capital inputs. The sources of these inputs are capital1equity1advances from the parties1unsecured loans etc, and each of them has an element of cost. This cost shall certainly affect the pricing of the product or service or others as the case may be, which the subject matter of the international transaction is. Thus, the Working capital constitutes an item of difference in matters of computation of arm’s length price1net margin. Therefore, the Tribunal has already decided this issue in the case of Mentor Graphics (Noida) (P) Ltd (Supra) that the ‘working capital’ constitutes a subject matter for adjustments in the matters relating to ALP in Transfer Pricing.
23. Now we shall undertake to explain the provisions of Rule 1OB of the Income Tax Rules 1962 in the succeeding paragraphs. The said Rules read as under:
Determination of arm’s length price under section 92C.
10B. (1) For the purposes of sub-section (2) of section 92C, the arm’s length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method, in the following manner, namely :-
(e) transactional net margin method, by which, –
(i) the net profit margin realized by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base;
(ii) the net profit margin realized by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base ;
(iii) the profit margin referred to in sub-clause (ii) arising is comparable uncontrolled transactions is adjusted to take into account the differences, if any between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market;
(iv) the net profit margin realized by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii);
(v) the net profit margin thus established is then taken into account to arrive at an arm’s length price in relation to the international transaction.
(2) For the purposes of sub-rule (1), the comparability of an international transaction with an uncontrolled transaction shall be judged with reference to the following namely :-
(a) the specific characteristics of the property transferred or services provided in either transaction;
(b) the functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to the transactions;
(c) the contractual terms (whether or not such terms are formal or in writing) of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions;
(d)conditions prevailing in the markets in which the respective parties to the transactions operate, including the geographical location and size of the markets, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition and whether the markets are wholesale or retail.
(3) An uncontrolled transaction shall be comparable to an international transaction if –
(i) none of the differences, if any, between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from, such transactions in the open market; or
(ii) reasonably accurate adjustments can be made to eliminate the material effects of such differences.
(4) The data to be used in analyzing the comparability of an uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered into :
Provided that data relating to a period no being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared.”
24. What does Rule lOB say in general: Thus, generally, as prescribed in rule 10B(1) of the Income Tax Rules, 1962, (i) the net profit margin (NPM) realized from international transaction is computed in relation to relevant base ie the (a) costs incurred or (b) sales effected or (c) assets employed or (d) any other relevant base; (ii) the said NPM realized from the comparable uncontrolled transaction is computed having regard to the same base; (iii) NPM realized from the comparable uncontrolled transaction mentioned in (ii) above is adjusted to taken into account the differences, if any; (iv) the differences, ifany mentioned are of that type which affect the amount of NPM in the open market; (v) finally the NPM at (i) above is established to be the same as the adjusted NPM mentioned at (iii) above. (vi) the said NPM shall be taken into account to arrive at the ALP in relation to the international transaction. Rule 10(3) also provides that, if none of the differences, if any are likely to materially affect the NPM or if such differences are adjusted with reasonable accuracy to eliminate the said differences.
A. Mentor Graphics (Noida) (P) Ltd reported in 109 lTD 101: On such precedent brought to our notice by the assessee before us relates to a decision of the Tribunal in the case of Mentor Graphics (Noida) (P) Ltd. 109 ITD 101. The assessee referred to the contents of para 27 of the order of the Tribunal for the proposition that the WC adjustments constitutes one which is required to be adjusted for the purpose of establishing the ALP. Relevant para reads as under.
“It is a simple principle of economics that the greater the risk, the greater the expected return (compensation). If there are material and significant differences in the risk involved, then the comparables identified are not correct as appropriate adjustments for differences in such cases are not possible. Therefore, while performing searches for potential comparable companies, not only turnover and operating profit but functions performed and risk profile are also to be considered. However, it can always be shown on the given facts of the case that comparables found are similar or almost similar to the controlled transaction and no adjustments are needed. It is useful to see the level of intangible assets in comparison to an appropriate base. Depending on facts of the case, final set of comparables may need to eliminate differences by making adjustments for the following:
(a) Working capital;
(b) Adjustment for risk and growth;
(c) Adjustment of R&D expenses.
The risk not only due to human resources, infrastructure and quality which are normally taken into account yet more significant risks like market risk, contract risk, credit and collection risk and risk of infringement of intellectual property are being ignored here. In most of the comparable
analysis carried in India, the latter type of risks is not being taken into consideration although these can lead to major difference in market value of transactions.”
B. E-gain Communication P Ltd reported in 118 lTD 243: The decision of Pune bench in the case of E-gain Communication P Ltd reported in 118ITD 243, is relevant and when TNMM is applied to a case, ‘the differences which are likely to materially affect the price, cost charged or paid in, or the profit in the open market are to be taken into consideration with the idea to make reasonable and accurate adjustment to eliminate the differences having material effect.’ If these differences are not eliminated or removed, the comparison becomes unsound and unreliable. Further also, the decision of the Delhi Bench in the case of Sony India P Ltd (114 ITD 448) was cited for the proposition that deduction of 20% is allowable for various differences on account of intangibles, R& D, risk factors, working capital, etc. referring to contents of the para 132 and 137 of the said decision, Sri Lohia stated that in that case the CIT(A) allowed adjustment to the extent of 10% against the 20% allowed by the TPO. Tribunal upheld the views of the TPO in the mater. Next one relates to an order of the Tribunal, Bangalore Bench, in the case of TNT India P Ltd supra, wherein it is mentioned that ‘similarly0 the working capital adjustments also have to be considered while arriving at the operating net margins.
27. Now, we shall cull out the relevant gist from the orders of the revenue and discuss the arguments of the parties:
Written submissions of the assessee in this regard are as under:
“Non grant of working capital adjustment: Hon ‘ble DRP in its directions has erred in not granting working capital adjustment to the unadjusted margins oft he comparable companies for F.~. 2005-06.
In this regards, the appellant would like to bring to the notice of your Honors that the margin of com parables for the FY 2005- 06 after considering working capital adjustment is determined at 3.77% as against the unadjusted arm’s length margin of the comparable companies of 7.18% determined by learned TPO considering data for FV2005-06 only.
The appellant in this regard, wishes to place reliance on following decisions which has upheld working capital adjustment:
|Mentor Graphics (Noida) Pvt. Ltd. (112 IT7 408) (Delhi ITAT)|
|Egain Communication (P) Ltd. I. ITO (118 ITD 243)|
|Sony India (P) Ltd v DCIT(114 ITD 448)|
|UCB India P Ltd Vs. ACIT(ITA 428 & 4291Mum107) (Mum)|
|TNTIndia Ltd. Vs. ACIT(ITANo.1442(BNG)108)|
The appellant prays that in determining the arm’s length price for the international transaction entered into by the appellant, the differences in working capital employed by the assessee vis-à-vis the com parables needs to be factored into. Also, after considering the benefit of the provisions of section 92C(2) of the Act providing for (+)(-) 5% adjustment, the appellant is at arm’s length in relation to its manufacturing imports.
Summarized below are the key figures1details calculating the adjustment after taking into consideration working capital adjustment:
|Relevant Operating Margin of Tested party -assessee||
|Arm’s length Operating Margin of Com-parables (unadjusted)||
|Arm’s length Operating Margin of Com parables (after considering working capital adjustment)||
|Adjustment after considering working capital
adjustments (3.77% – 2.41%)
|Adjustment after considering working capital
adjustment and benefit of +1- 5%
28. Elaborating on the above written submissions, the Assessee submitted before us that the issue of adjustments relating to Working Capital was raised before the revenue authorities and they passively allowed the issue to slip out of the active consideration. In this regard, Ld Counsel read out the contents of para 7.3.1 of the guidelines of the DRP and the same read as follows.
7.3.1 As regards the adjustment made to the manufacturing activit9, as a result of which the income of the assessee has gone up by Rs 1,11,25,6701-, it may be mentioned that after careful consideration of material on record, we are of the view that the Id TPO has given cogent reasons for coming to the conclusion that the bench marking of assessee’s international transactions falling under manufacturing activity is required to be done following the TNMM and taking com parables as has been adopted by the assessee in the Transfer Pricing study Report and considering their data for the A~ 2005-06…. The TPO has already given detailed reasons for adopting PLI of proposed set of com parables at 7.18%. On the given facts, the same is found to be acceptable. Therefore, ….the action of the TPO …does not require any interference.
29. As seen from the above, the DRP passively relied on the TPO’s findings bystating that ‘Id TPO has given cogent reasons for coming to the conclusion that the bench marking of assessee’s international transactions falling under manufacturing activity is required to be done following the TNMM and taking com parables as has been adopted by the assessee’. On receipt of the said guidelines of the DRP, the AO dutifully adopted the same in his order. But the fact is that the written objections raised by the assessee before the DRP are left unattended by Ld DRP. To be specific, there is no discussion either in the order of the AO or in the guidelines of the DRP on if the ‘working capital’ adjustments fall within the zone of eligible adjustments and if they constitute material difference or otherwise. We infer that the revenue is of the implied opinion that the assessee becomes ineligible for any adjustments the moment the set of comparable are provided by him. In our opinion, this approach of the revenue is supported by the law or rules in existence. Rule 10B(3) provides for the guidelines as to eliminate the difference, if any and the legitimate way of bench marking of the International transactions for ALP purpose involves such eliminations. It is the duty of the AO1TPO1DRP to minimize1eliminate the difference if any, which is likely to materially affect the price as discussed in Rule 10(3) of the Income tax rules, 1962. At the end of the assessment proceedings, the prayer of the assessee relating to the adjustments on account of working capital, was not attended either by the DRP by the AO. Yes, it is true that the assessee did not raise this issue before the TPO as evident from the order of the TPO but the same were raised before Ld DRP, who summarily relied on the order of the TPO as discussed in para 7.3.1 extracted above and without even examining if the request for working capital adjustment was raised at all before the TPO.
Therefore, we direct them to allow the requisite adjustment on account of the impugned ‘working capital’ while determining the Arm’s Length operating Margin of the Comparables. Thus, relevant grounds of assessee’s appeal are allowed.
32. Meaning of ‘Likely to materially affect ‘- Quantification: Now we shall take if the quantity of the said ‘working capital’ adjustments is that much which is likely to materially affect the price1margin of the international transactions involved. As per the assessee, unadjusted Arm’s length Operating Margin of the Comparables is 7.18% and Arm’s length Operating Margin after making adjustments on account of ‘working capital’, works out to only 3.77%. It shows the drop in margins to the extent of 3.41% in the Arm’s length Operating Margin of the Comparables. We have already discussed these figures in the preceding paragraphs and on translation to real figures, the said percentage of 3.41 works out to Rs 31,72,0991-. In our opinion, in the given case, such a difference constitutes the said ‘difference, if any’ which is likely to materially affect the ALP1 Arm’s length Operating Margin of the Comparables as mentioned in Rule 10B(3) of the Income tax rules, 1962. The same needs to be eliminated as per the said sub-rule (3).
33. We have already discussed in the preceding paragraphs, this issue of adjustment on account of WC was raised for the first time before the Ld DRP and the DRP has passively relied on the order of the TPO without realizing that the said issue was never dealt with by the TPO. Therefore, the issue of granting of adjustment on account of ‘working capital’ for eliminating of the material effects and the issue of, if such adjustment © 3.41% constitutes that difference, if any, which is likely to materially affect the price1profit margin, have not been examined. We find that there are written request of the assessee to the DRP to this extent and assessee furnished the relevant figures, which are enough to adjudicate the said request by the AO1DRR. It is not the case of the DRP that the above claims of the assessee are incorrect. Alternatively, it is not the request of the revenue’s DR that these said issues should be remitted for another round of the proceedings before the revenue authorities. In our opinion, the existence of difference © 3.41%, which is worth Rs 31,72,0991-, attributable to the ‘working capital’ ought to amount to the ‘material difference’ considering the existing unadjusted operating margin of the comparables at 7.18%. In these circumstances, we are of the opinion that the said working capital differences constitutes quantitatively likely to materially affect the ALP 1 AL Operating Margin of the comparable. Therefore, the claims of the assessee are allowed. Accordingly, the grounds 4(a) is covered by the cited decisions and is allowed pro tanto.
Issue of import cost of raw material, components and spares
34. Ground 4 (b) has two limbs i.e. warranty claim and trade import cost of raw material and components and spares. Ld counsel mentioned that the adjustments with regard to the warranty claims are not pressed. Therefore, the limited issue for adjudication out of this said sub ground (b) relates to the adjustment on account of higher import cost. In this regard, Ld counsel submitted that the assessee provided the commercial reasons in relation to grant of adjustment on account of higher import cost of the assessee vis a vis the comparable companies before the TPO1DRP. The relevant write up by the assessee on this issue of import cost related adjustment read as under:
The company has 35.71% higher imports as compared to its comparable companies. Further, the additional cost incurred by the Company as compared to comparable companies on basis custom duty, landing charges, clearing and forwarding charges and insurance & freight will be around 18% to 21%.
Summarized below are the key figures/details
|Operating profit/ total sales (adjusted for higher import cost||
|Arm’s length Operating Margin of Comparables (unadjusted)||
|Adjustment after considering adjustment for high import cost (Rs 233,242,565* (7.18% – 6.61%=0.57%)||
The appellant places reliance on rule 10B(3) of the Rules and the OECD Guidelines, which lays emphasis on adjustment for difference between the transactions being compared which are likely to materially affect the profit arising from such transactions in the open market for which reasonably accurate adjustments are possible. Thus the differences on account of higher imports and warranty provision have resulted into lower profit as compared to the transactions in the open market for which reasonable adjustment is possible.
In view of the above, the appellant submits that the margins of appellant be adjusted to take into consideration excess warranty claims and high import cost.
37. We have heard the parties and perused the available material on records in the light of the second limb of the ground 4(b). It is relevant mentioned that we have already analysed the relevant provisions of Income Tax rules vis avis the scope of the adjustments in the preceding paragraphs in the context of the adjustments on account of the ‘working capital’. In principles, our findings on the issue remain applicable to the adjustments on account of the import cost mentioned in ground 4(b) too. The difference between the AL Margin before and after the said adjustments on account of ‘import cost’ works out to 0.57% (7.18%-6.61%). Revenue has not disputed the said working of the assessee. In these factual circumstances and in the light of the scope of adjustments discussed above, in our opinion and in principle, the assessee should win on this ground too. One such decision relied upon by the assessee’s counsel supports our finding relates to the decision of this bench of the Tribunal in the case of Skoda Auto India p Ltd 122 TT3 699 (Pune) dated March 2009 wherein, it is held (in para 19 of the order) that,- No doubt , a higher import content of raw material by itself does not warrant an adjustment in operating margins, as was held in Sony India (P) Ltd. ’s case (supra), but what is to be really seen is whether this high import content was necessitated by the extraordinary circumstances beyond assessee ’s control. As was observed by a Co-ordinate Bench of this Tribunal in the case of E-Gain Communication (P) Ltd. (supra) “the differences which are likely to materially affect the price, cost charged or paid in, or the profit in the open market are to be taken into consideration with the idea to make reasonable and accurate adjustment to eliminate the differences having material effect”. We do not agree with the AO that every time the assessee pays the higher import duty, it must be passed on to the customers or it must be adjusted for in negotiating the purchasing price. All these things could be relevant only when higher import content is a part of the business model which the assessee has consciously chosen but then if it is a business model to import the SKD kits of the cars, assemble it and sell it in the market, that is certainly not the business models of the comparables that the TPO has adopted in this case. The adjustments then are required to be made for functionally differences. The other way of looking at the present situation is to accept that business model of the assessee company and the comparable companies are the same and it is on account of initial stages of business that the unusually high costs are incurred. The adjustments are thus required either way. It is, therefore, permissible in principle to make adjustments in the costs and profits in fit cases. We also do not agree with the authorities below that the onus is on the assessee to get all such details of the comparable concerns so as to make this comparison possible. The assessee cannot be expected to get the details and particulars which are not in public domain. In such a situation, i.e. when information available in public domain is not sufficient to make these comparisons possible, it is inevitable that some approximations are to be made and reasonable assumptions are to be made. The argument before us was that it was first year of assessee ’s operations and complete facilities ensuring a reasonable indigenous raw material content was not in place. The assessee’s claim is that it was in these circumstances that the assessee had to sell the cars with such high import contents, and essentially high costs, while the normal selling price of the car was computed in the light of the costs as would apply when the complete facilities of regular production are in place. None of these arguments were before any of the authorities below. What was argued before the AO was mere fact of higher costs on account of higher import duty but then this argument proceeded on the fallacy that an operating profit margin for higher import duty is permissible merely because the higher costs are incurred for the inputs. That argument has been rejected by a Co-ordinate Bench and we are in respectful agreement with the views of our esteemed colleagues. This additional argument was not available before the authorities below and it will indeed be unfair for us to adjudicate on this factual aspect without allowing the TPO to examine all the related relevant facts. We, therefore, deem it fit and proper to remit this matter to the file of the TPO for fresh adjudication in the light of our above observations.
38. The perusal of the impugned orders shows that the above cited guidelines by way of decision of this bench of the Tribunal in the case of Skoda Auto India p Ltd (supra) were not available to the revenue authorities. Therefore, we are of the opinion, the issue should be set aside to the files of the TPO with direction to examine the claim of the assessee relating to the import cost factor and eliminate the difference if any. However, the TPO7AO7DRP shall see to it that the difference in question is ‘likely to materially affect’ the price7profit in the open market as envisaged in sub rule (3) of Rule 10B of the Income tax Rules, 1962. Accordingly, ground 4(b) is allowed pro tanto.
Issue of TP adjustment without giving benefit of #1-5%
under erstwhile proviso to section 92C(2) of the Act:
39. Ground no.9 relates to applicability of the provisions of the proviso to section 92C(2) of the Act. We reproduce the relevant extract from the written submissions of the assessee as it is a self contained one and it bring out briefly (i) the stand of the revenue and (ii) the rebuttal of the assessee. The submissions in this regard are as follows: “Transfer pricing adjustment without giving benefit of +7-5% as available under erstwhile proviso to section 92C(2) of the Act……
Honrable DRP and the learned AO7TPO have erred in facts and circumstances of the case by computing the arm’s length price of the international transactions pertaining to manufacturing activity and export of components and spares without taking into account the +7- 5 percent variation from the mean, which is permitted to and which has also been opted for by the appellant underthe provisions of section 92C(2) oft he Act.
Honrable DRP and the learned AO7TPO has contended that the benefit of safe harbor of +57-5% is not available to the appellant stating the following:
“In the present case it is seen that the ALP of the international transaction undertaken by the assessee falls beyond the 5% of the price of International Transaction computed by the assessee. Therefore in view of the provisions of the law, details and intentions as are evident from the press note of govt. of India as well as circular of the CBDT, as aforementioned the benefit of the safe harbor of #15-5% is not available to the assessee.”
The appellant is contesting the above conclusion of the Honrable DRP and with respect to its contention that the transfer pricing adjustment, if any0 should be made after giving the benefit of +7-5%, the appellant places its reliance on the following cases:
Cummins India Limited [ITANo.277 & 14127PN707](Pune ITAT)
DCIT Vs. Sony India TS-19-ITAT-2008(DEL)(Delhi ITAT)
ACITvs. UETrade Cortn (India) Pvt. Ltd(2010) – [ITANo.4405(Del)72009
Starent Networks (India) P Ltd v. DCIT[ITANo. 13507PN72010](Pune ITAT)
M7s. SAP Labs India Pvt. Ltd. vACIT(ITANo.3987Bang72008) Bang ITAT
Tecnimount ICB Private >imited [ITANo. 709 81Mum12919](Mumbai ITAT)
Huntsman Advanced Materials India Pvt. >imited ITANo. 82371Mum12010
ITO Vs. Hartland Info & Consultancy Services Ltd. ITANo.5175(Del) ITAT)
Further the appellant submits that as per the proviso to section 92C(2) of the Act, an assessee has the option of charging a price to its AEs, which may vary from the arm’s length price by +1- 5 percent. The appellant also wishes to state that Section 92CA(3) of the Act provides that the Transfer Pricing Officer has to determine the arm’s length price in accordance with sub-section (3) of section 92C. Section 92C(3) further states that the arm’s length price shall be determined by the Assessing Officer in accordance with sub-section (1) and (2) of section 92C. Therefore, it should be appreciated that the learned Transfer Pricing Officer is mandatorily required to calculate the arm’s length price in accordance with section 92C(1) and 92C(2) of the Act.
The explanatory Memorandum to Finance Bill 2002 and Notes on Clauses – Income Tax(Finance Bill0 2002) also clarifies that in case the application of the most appropriate method results in two or more prices, the appellant is required to compute the arm’s length price by determining an arithmetic mean of such prices or a 5% variation of the arithmetic mean thereof. There is no ambiguity in law in respect of the same. Thus, any adjustment to the income of the assessee should be computed after considering #1-5% variation from the arithmetic mean.
With respect to the amendment made by the Finance Act 2009 and explanatory memorandum to the Finance Bill, 2009, the appellant wishes to state that the explanatory memorandum to the Finance Bill, 2009 states that “the amendment would apply to all cases where the proceedings are pending before the TPO on or after 1 Oct 2009”. However, it is submitted that wordings in the explanatory memorandum which are against the language of the law should not be resorted to unless the language of the section is not clear or unambiguous.
Section 92 deals with the computation of income having regard to the arm’s length price. Further, the amendment to section 92C refers to the “computation of the arm’s length price.” Thus, the amendment is to the substantive provisions dealing with the computation of income and not to the procedures dealing with the assessment of income. Thus, the proviso which is made effective with prospectively from 1 October 2009 should not be made applicable for the transactions undertaken by the appellant during the financial year ended 31 March 2006 i. e. before 1 October 2009.
Further the learned TPO and Honrable DRP has failed to appreciate the contention of the appellant documented in the TP study report that prescribing a range for determining arm’s length price would help accommodate for wide differences between the functions performed, risks undertaken, business circumstances and other similar circumstances pertaining to the ‘tested party’ vis-à-vis the comparables. A similar view is endorsed by OECD guidelines. “It also is important to take into account a range of results when using the transactional net in the business characteristics of associated enterprises and any independent enterprises engaged in comparable uncontrolled transactions, because the range would permit results that would occur under a variety of commercial and financial conditions.”
Thus, drawing reference from the position as per the provisions of the Act, also supported by various judicial precedents and OECD Guidelines, the appellant submits that benefit of +1- 5per cent variation in determining the arm’s length price needs to be given in the instant case in case the Honrable ITAT proposes to continue with the transfer pricing adjustment in the case of the appellant. The appellant prays that the adjustment (if any) be made after allowing the benefit of +1- 5% variation from the arithmetic mean arm’s length price.”
Operating Revenue as P11
|Tested Party Total Cost||
|Tested Party Total Sales||
|Tested Party Profits||
|Operating Profit1total sales||
|ALOM* of Comparable after Working Capital adjustments||
|Difference in Margins (3.77- 2.41)||
*Arm’s Length Operating Margin
42. Without prejudice to the above, as given in the note, Ld Counsel mentioned, that there are various decisions of the Tribunal including the decision of the coordinate bench of the ITAT, Pune in favour of grant of deduction of 5% when multiple prices are involved and cited Cummin India Ltd ITA 277114121PN12007 and Starent Networks (I) P Ltd ITA NO 13501PN12010. In this regard, Ld Counsel cited a paragraph from the order of the Tribunal in the case of cited case from the Hyderabad Bench of the ITAT in the case of Deloitte Consulting India P Ltd, supra stating that the order of the Co-ordinate Bench of the Tribunal will normally to be followed in case where there are contrary decisions of two Benches of the Tribunal.
Issue relating to computation of TP Adjustments on Proportionate Basis:
45. Ground 10 refers to incorrect computation of TP adjustments to the manufacturing activity. In this regard, referring to the manufacturing segment and sale affected in this segment, Sri Lohia read out that the total sale of this segment is Rs 23,32,42,5651- and the relatable cost of material is Rs 1528.65 lakhs, (of course, the assessee submitted a different figure of Rs 1557.39 lakhs in some other context). Thus, this cost of material (controlled and uncontrolled cost) of Rs 1557.39 lakhs includes the Rs 602.19 lakhs, relatable to the transactions with AEs ie controlled cost. As per the Counsel, revenue has erred in computing the TP adjustment on the entire manufacturing segment sales instead of computing the TP adjustment on those sales relatable to the import of the components and spares procured from the AEs only. While establishing the ALP on this segment, the AO worked out the said variance © 4.77% (i.e. 7.18% – 2.41%) and worked out the corresponding quantum of adjustment at Rs 1,11,25,670/- (i.e. 4.77*23,32,42,5651100). In this regard, the Ld counsel for the assessee mentioned that if total international transactions under consideration for adjustment on account of ‘Import of raw materials, components and spares for assembly1manufacture of material handling products’ worth Rs 60,218,8781- works out to only 40% of the total cost, the same proportion of the total sales has to be considered for making TP adjustments. If the assessee’s manner of adjustment is considered the additions should be restricted to Rs 43,82,7831- only (Rs 11,125,670 * Rs 60,218,8781Rs 152,865,285). In this regard, Ld Counsel relied on the provisions of the Rule 10B(1)(e) and also various judicial pronouncements on the subject ie (i) Emerson process Management India P Ltd ITA NO 81181m12010; (II) T Two International P Ltd and others; IL 3in electronics I PLtd 36 SOT 227 Del; Starlite case 20 10-TII-28-ITAT-DEL-TP; Abhishek Auto Industries Ltd 201 0-TII-54-ITATDEL-TP etc.
46. We have heard the parties and perused the relevant provisions of the said rule. Sub clause (i) and (ii) of the Rule 10B(1)(e) referred to the expressions ‘in relation to’and the ‘relevant base’. They read as follows:
(i) The net profit margin realized by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base;
(ii) The net profit margin realized by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base;
47. From the above, it is vivid that in TNMM, the net profit margin realized by the tested party, an assessee, out of the international transaction is computed in relation to sale effected (as in assessee’ case), which is the relevant base. The expression ‘in relation to’ means ‘in connection with’ and it implies connection between impugned international transactions worth Rs 60,218,8781- on account of Import of raw materials, components and spares for assembly1manufacture of material handling products’ and to the related sales and not to the entire sales of the manufacturing segment of the assessee. The said relationship1ratio is the requirement in the present comparability analysis and not the entity level sales as wrongly considered by the TPO and relied upon by the DRP. In principle, such closure comparability analysis is needed in TNMM, when sales is used as a base for determining net profit margin. Thus, it is erroneous to bring relationship between the Rs 60,218,8781- and Rs 23,32,42,5651- ie the total sales. Assessee’s failure to supply the data on relevant sales is no defense, when there are settled alternatives for adoption in such circumstances, well tested ‘principle of proportionality’ in our opinion should help. Thus, the base of sales does not need to be ‘total sales’; but the proportionate sales relatable to the impugned international transactions. It is a commonsensical approach.
48. In this regard, we have perused the existing decisions relied upon by the assessee and the following extracts from some of the decisions are relevant and the same read as follows.
A. Emersons Process Management India P td— ITA NO 81181M12010AN-2006-07 -Pg 452 of Paper Book
19. Difthly, as has been consistently held by the coordinate benches, the transfer pricing adjustment is to be made with respect to international transaction and not the entries sales………….We, therefore, direct the Assessing Officer to compute the transfer pricing adjustment in the light ofthis legal position. O
B. T Two International P Ltd and Tara Jewels Eøorts P Ltd and Tara Ultimo P Ltd ITA NO 5644, 5645 & 5646/m/2008 Ay 2004-05—para 13 age 460 of Paper Book
” 13. We have considered the rival submissions carefully. We partially agree with the submissions of the ld. Counsel for the assessee that original TPO’s order is definitely erroneous because he has applied the net profit margin of 7.25% on the gross sales and followed a complicated procedure to arrive at the amount of adjustment. In simple terms if the sales to Associated Enterprises is taken at Rs. 25 crores and straight way 7.25% margin is applied then approximately total margin would be Rs. 1.81 crores, whereas adjustment has been made at Rs2,57,26,138/-…”
C. IL Jin Electronics I P LtdvACIT36 5OT227 Page 470 of the Paper Book:
“15. The assessee has also taken one alternative ground out of the total raw materials consumed by the assessee for manufacturing printing circuit boards, only 45.51 per cent of the total raw materials were imported through assessee’s associated concerns, and, therefore, any adjustment, if any called for, can only be made to the 45.51 per cent of the total turnover, and not to the total turnover of the assessee. After considering the facts of the case, we do not find any difficulty in accepting this contention of the assessee that at best only 45.51 per cent of the operating profit can be attributed to imported raw material acquired from assessee’s associate concerns. In the present case, the AO has calculated the operating profit on the entire sales of the assessee, which in our considered opinion, is not justified, when it is admitted position that only 45.51 per cent of raw material has been acquired by the assessee from its associate concerns for the purpose of manufacturing items. The assessee has 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 addition to the profit shown by the assessee. We, therefore, direct the AO to modify the assessment and make the adjustment only to the extent of difference in the arm’s length operating profit with adjusted profit with reference to the 45.51 per cent of the turnover, and not to the total turnover of the assessee. Therefore, to this extent, the addition made by the AO and further confirmed by the CIT(A) is reduced. We order accordingly.”
D. DCIT vs Starlite 133 TT7 425 Mum AN 2002-03 Page Para 13 at 478 of the Paper Book
“13 . As in this case, TPO has not applied TNMM, as contemplated in the Act, we have no other alternative but to set aside her order………..We also agree with the arguments of learned counsel for the assessee that adjustments, if any, arising due to computation of ALP should be restricted only to the international transactions and not to the entire turnover of the assessee company. No addition can be made to local transactions under Chapter X of the Act.
Such things are done only when the AO invokes s. 144. We direct the AO to restrict the adjustments, if any only to international transactions, which are found by him to have taken place at price otherthan ALP.”
E. Abhishek Auto Industries Ltd vs DCIT 136TT7530 Del-ara 8.2 at Page 494 of the Paper book:“8.2 It has not been disputed that provisions X, s. 92C deals with international transactions only and not with transactions which have no international cross-border element at all. Therefore, the basis of making the adjustments on the enterprise level by taking Rs.68.76 crores as the base is not correct. What should have been taken is the sale to domestic parties using Takata technoloty and Takata raw material amounting to Rs. 12.74 crores. The segment that was to be looked at was the international segment, that is domestic sale using foreign technology and foreign raw material. As given by the appellant, the operating profit margin on AE sales is 10.49 per cent whereas in the domestic sales segment it is only 2.88 per cent………………We, therefore, accept this second proposition also that only international transaction is to be taken into account while calculating the ALP’.
Order pronounced in the open Court on 04.01.2012