2015 (11) TMI 1729 - HC - Income Tax

Court excludes stock obsolescence provision from operating margin calculation, rules in favor of Assessee.

The court ruled in favor of the Assessee on all issues. The provision for stock obsolescence was excluded from the net operating expenditure for ... Determining the net operating margin - Provision for stock obsolescence/inventory be excluded from the net operating expenditure of the Assessee for since it was an abnormal and extraordinary expenditure - adjustment to the value of import of raw materials - Held that:- Court is unable to discern any legal infirmity in the approach of the CIT (A) which was upheld by the ITAT in the impugned order. It is sought to be suggested that the Assessee makes a provision for stock obsolescence year after year and, therefore, this could not be treated as ‘extraordinary’ or ‘non-recurring’. However, when one peruses the order of the CIT (A) it is seen that the question was not whether the Assessee was claiming it only as a one-time measure but whether it was gaining any undue advantage in using this device as a measure for avoiding tax. Ultimately, the entire exercise of determining ALP for international transactions is to ensure that there is no avoidance of tax by an Assessee by resorting to an accounting device. The Court is unable to hold that the provision made for stock obsolescence by the Assessee resulted in any undue advantage to it. The comparability analysis undertaken by the CIT (A) which has been affirmed by the ITAT does not suffer from any legal infirmity. No substantial question of law arises Issues:1. Whether provision for stock obsolescence should be excluded from the net operating expenditure for determining the net operating margin.2. Whether the international transactions between the Assessee and its associated enterprise were at arm's length.3. Whether the provision for stock obsolescence was abnormal and extraordinary in nature.4. Whether the Assessee gained any undue advantage in using the provision for stock obsolescence as a measure for avoiding tax.Analysis:1. The primary issue in this case revolved around whether the provision for stock obsolescence should be excluded from the net operating expenditure for determining the net operating margin. The CIT (A) accepted the plea of the Assessee that the provision for stock obsolescence should be excluded since it was abnormal and extraordinary in nature. The CIT (A) analyzed the stock obsolescence to sales ratio for comparable companies and found that the provision for stock obsolescence was significantly higher for the Assessee compared to its comparables. The CIT (A) concluded that the provision for stock obsolescence needed to be excluded for computing the operating margin of the Assessee, aligning with the principle that abnormal expenses should not be included in determining operating margin.2. Another issue addressed in the judgment was whether the international transactions between the Assessee and its associated enterprise were at arm's length. The Assessee applied the Transactional Net Margin Method and contended that the operating margin on operating income was higher than the mean of the weighted average margins earned by comparables, indicating that the transactions were at arm's length. The TPO, however, re-computed the net operating margin and made adjustments, leading to a downward adjustment in the value of imports. The CIT (A) and ITAT upheld the Assessee's position, affirming that the international transactions were at arm's length.3. The question of whether the provision for stock obsolescence was abnormal and extraordinary in nature was extensively discussed in the judgment. The CIT (A) compared the provision for stock obsolescence of the Assessee with that of comparable companies and found a significant difference, particularly noting that only one comparable company had a similar provision. The CIT (A) concluded that the provision for stock obsolescence was abnormal and extraordinary, justifying its exclusion from the operating margin calculation of the Assessee.4. Lastly, the judgment addressed the issue of whether the Assessee gained any undue advantage in using the provision for stock obsolescence as a measure for avoiding tax. The Court examined the purpose of determining the arm's length price for international transactions, emphasizing the prevention of tax avoidance through accounting devices. The Court found no legal infirmity in the comparability analysis conducted by the CIT (A) and upheld by the ITAT, dismissing the argument that the provision for stock obsolescence resulted in undue tax advantage for the Assessee.