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

Brief of the case:

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

Facts of the case:

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

Held by CIT (A):

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

Inclusion/exclusion of companies in the list of comparables

(1) M/s Eicher Motors

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

(2) M/s Force Motors

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

Capacity utilization adjustment

Facts:

• Assessee claimed to have worked at a capacity of 29% during the year in question. It was further claimed that the three comparables chosen by it worked at the average capacity utilization of 44%.
• Hence, the assessee claimed capacity utilization adjustment by reducing its operating costs accordingly.
• As per report of cost accountantt, the capacity utilization of the assessee as well as the comparables was initially raised to 100%.
• The assessee reduced its operating costs by considering its capacity utilization vis-à-vis that of comparables and resultantly claimed that its increased profit as a result of such reduced operating costs be compared with that of the comparables.
• The TPO has also agreed in principle with the otherwise availability of the capacity adjustment.
• The lower authorities have reduced the amount of adjustment by excluding certain costs from the ambit of the costs qualifying for adjustment.
• According to ITAT, the issue of allowing capacity adjustment before us can be divided into two sub-issues for consideration, viz., first, whether the adjustment should be allowed in the hands of the assessee as has been done by the authorities below or comparables and second, how to compute capacity utilization adjustment under the TNMM.

Capacity adjustment should be allowed in whose hands?

• The answer to above question was linked to the manner of computation of the arm’s length price under TNMM, which has been set out in Rule 10B(1)(e).
• Sub-clause (i) in the process of determination of the ALP under the TNMM talks of the computation of net operating profit margin realized by the assessee from an international transaction.
• Sub-clause (ii) is the computation of net operating profit margin realized by an unrelated enterprise from a comparable uncontrolled transaction.
• This refers to determining the operating profit margin of comparables with the same base as that of the assessee.
• Sub-clause (iii) provides that the net profit margin realized by a comparable company.
• It is this adjusted net profit margin of the unrelated transactions or of the comparable companies, as determined under sub-clause (iii).
• Sub-rule (2) of Rule 10B provides that the comparability of an international transaction with an uncontrolled transaction shall be judged with reference to certain factors which have been enumerated therein.
• In this case the authorities below have adjusted the operating costs of the assessee in allowing the capacity adjustment. As against that, the correct course of action provided under the law is to adjust the operating costs of the comparable and their resultant operating profit.
• Once the law enjoins for doing a particular thing in a particular manner alone, it is not open to anyone to adopt a contrary or different approach.
• No mechanism has been given under the Act or the rules for computing the amount of capacity utilization adjustment.
• Hence impugned order is set aside and restored to the file of AO on this issue.

How to compute capacity utilization adjustment under TNMM?

• Under the TNMM, the ALP of an international transaction is determined by computing and comparing the percentage of operating profit margin realized by the assessee with that of the comparables.
• Under the TNMM, the first step in granting capacity utilization adjustment is to ascertain the percentage of capacity utilization by the assessee and comparables.
• The second step is to give effect (positive or negative) to the difference in the percentage of capacity utilizations of the assessee vis-à-vis comparables, one by one, in the operating profit of comparables by adjusting their respective operating costs.
• Operating costs can be either fixed or variable or semi-variable. One needs to split semi-variable costs into the fixed part and variable part.
• TPO as well as CIT (A) have proceeded on a wrong premise by considering all the comparables as one unit with the average percentage of their respective capacity utilizations.
• ITAT further held that in the calculation of such capacity utilization adjustment, the CIT(A) has considered four companies as comparable, which view has been modified inasmuch as ITAT have held that M/s Eicher Motors and M/s. Force Motors are incomparable.
• In the absence of the availability of financials of all the comparable companies, it is not possible to work out the amount of capacity adjustment in the manner discussed above.
• ITAT set aside the impugned order and direct the TPO/AO to work out the amount of capacity utilization adjustment afresh.
• Regarding claim of Rs.37,03,000/- on account of deferred revenue expenditure ITAT confirmed the order of CIT (A) by following the precedent in the assessee’s own case in earlier year.