2015 (4) TMI 949 - HC - Income Tax

Comparables with High Margins Can Be Used After Rule 10B(3) Analysis; Section 36(1)(ii) Allows Bonus Deductions

The HC held that comparables with exceptionally high profit margins cannot be excluded solely on that basis; a Rule 10B(3) analysis must determine if ... Applicability of proviso to Rule 10B(4) - fluctuations in the operating profit margins of comparable companies during the relevant financial year under question as compared to earlier years - differential functional and risk profile coupled with high volatility in operating profit margins as grounds for rejecting comparables - whether comparables can be rejected on the ground that they have exceptionally high profit margins as compared to the assessee in transfer pricing analysis - Disallowances under Section 36(1)(ii) - bonus paid to shareholders - Held that:- This Court proceeds on the basis that there is sufficient guidance and clarity in Rule 10B on the principles applicable for determination of ALP. These include the various factors to be taken into consideration, approach to be adopted (functions performed, taking into account risks borne and assets employed, size of the market, the nature of competition, terms of labour, employment and cost of capital, geographical location etc). The extent of accurate adjustments possible, too, is a factor to be considered. Rule 10B (3) then underlines what the ALP determining exercise entails, if there are dissimilarities which materially affect the price charged etc: the first attempt has to be to eliminate the components which so materially affect the price or cost. In other words, given the data available, if the distorting factor can be severed and the other data used, that course has to be necessarily adopted. The mere fact that an entity makes high/extremely high profits/losses does not, ipso facto, lead to its exclusion from the list of comparables for the purposes of determination of ALP. In such circumstances, an enquiry under Rule 10B(3) ought to be carried out, to determine as to whether the material differences between the assessee and the said entity can be eliminated. Unless such differences cannot be eliminated, the entity should be included as a comparable. While determining the comparability of transactions, multiple year data can only be included in the manner provided in Rule 10B(4). As a general rule, it is not open to the assessee to rely upon previous year's data. In the present case, this Court holds that once Brescon, Keynote and Khandwala Securities are held to be functionally similar to the assessee, they would be included as comparables, notwithstanding their high profit margins, provided that the material difference on account of such high profit margins can be eliminated under the Rule 10B(3) analysis. This Court, on a perusal of the orders of the lower authorities and the assessee's submissions before them which have been placed on record in this appeal, finds that the assessee's contentions with respect to the exclusion of Brescon and Khandwala Securities were based only on their exceptionally high profit margins for the assessment year in question and not on the grounds of functional dissimilarities. Indeed, the assessee did not contend the latter before the lower authorities. The assessee has sought to highlight differences in the risk profiles of the assessee and Brescon in the present appeal. However, this Court holds that such a contention cannot be raised for the first time at this stage. Therefore, Brescon and Khandwala Securities are held to be functionally similar, and the matter is remitted to the DRP for the purposes of examination under Rule 10B(3) of the Rules. In the event that the material differences arising out of the extremely high profits cannot be eliminated as per Rule 10B(3), these two entities will have to be discarded as comparables. As far as Keynote is concerned, this Court notices that the assessee had challenged its inclusion as a comparable on two grounds: a) differences in the activities of Keynote and the assessee; and b) exceptionally high profit margins. The TPO rejected the first ground relying on the fact that the assessee had used it as a comparable for previous years and in the subject assessment year as well, it qualified as a comparable based on the assessee‟s search process. Further, the TPO held that Keynote was engaged in financial consultancy and would therefore be considered as a comparable. The ITAT, for reasons unknown, did not examine this issue. This Court notes that the assessee is engaged in the business of rendering financial research and advisory services. It is responsible for investigation and advice to some of its group companies on structuring potential investments and exit opportunities; advising the group companies of investment and disposition opportunities; collection and dissemination of financial information of prospective entities; and other related services. On the other hand, Keynote, as per its Directors‟ Report for FY 2007-08, is involved in “Lead Managing IPOs, Rights Offers, Buybacks and Takeovers. [It] also expanded its reach in Corporate Finance & M&A Advisory.” The services provided by Keynote also include managing public issue of securities, underwriting, project appraisal, equity research, capital restructuring, loan and lease syndication, placement services, portfolio management, debenture trustee, managing/advising on international offerings of debt/equity, private placement of securities, etc. Evidently, the assessee does not provide any of these services enumerated above. Given such functional differences and the mandate of Rule 10B(2)(b), there could be merit in the argument that Keynote cannot be considered a comparable for determining the ALP. The fact that the assessee had included it in the previous assessment years does not have any bearing on its inclusion for the subject assessment year. In this regard, this Court relies on the Supreme Court's decision in Commissioner of Income Tax v. C. Parakh & Co (India) Ltd. [1956 (3) TMI 1 - SUPREME COURT] and CIT v. Bharat General Reinsurance -[1970 (12) TMI 5 - DELHI HIGH COURT] has also held that there is no estoppel against law under the Act. Thus this Court remits the matter for consideration to the DRP to properly apply the test indicated in this judgment and analyse the functional similarity of Keynote with the assessee. In the event that the DRP finds them to be functionally comparable, it would proceed to carry out the Rule 10B(3) analysis as in the case of Khandwala Securities and Brescon. Deduction under Section 36(1)(ii) in respect of the bonus paid by it to its two shareholders - lower authorities denied such claim, holding that the bonus was paid to the shareholders in lieu of dividend with the objective of avoiding tax - Held that:- perusal of an excerpt from the DRP‟s order dated 21.09.2012 quoted by the AO in his order dated 19.10.2012 contradicts both these facts: a) bonus was not paid in the ratio of 2:1 and b) the assessee had declared interim dividend of ₹ 5,47,47,000/-. Further, the bonuses paid to the two shareholder-directors in the preceding two financial years were in the ratio of 60-65%:40-35%, even though their shareholding was 1:1. The balance sheet of the assessee placed on record also indicates that the two shareholders also hold directorial positions in the assessee. Therefore, the assessee‟s contention that the bonus was paid to the shareholders in their managerial capacity, like in the case of other managers, cannot be questioned merely on the basis of a speculation by the revenue that such payment was to avoid tax. In such circumstances, the deduction under Section 36(1)(ii) in respect of payment of bonus to the two shareholder-directors is allowed. - Decided in favour of assessee. ISSUES: Whether the concept of 'super profit' exists in the arm's length price (ALP) determination under the Income Tax Act, 1961 or the Rules, permitting exclusion of high profit making companies from comparables.Whether the proviso to Rule 10B(4) of the Income Tax Rules, 1962 allows use of multiple year data for comparables in case of fluctuations in operating profit margins.Whether comparables can be rejected solely on the ground of exceptionally high profit margins compared to the assessee in transfer pricing analysis.Whether differential functional and risk profiles coupled with high volatility in operating profit margins justify rejection of comparables.Whether disallowance under Section 36(1)(ii) of the Act is justified when bonuses paid to shareholder-employees are not in exact proportion to shareholding and there is no tax avoidance. RULINGS / HOLDINGS: The mere fact that an entity makes high/extremely high profits or losses does not ipso facto lead to its exclusion from the list of comparables; an enquiry under Rule 10B(3) must determine if material differences can be eliminated, failing which exclusion is warranted.Rule 10B(4) mandates that data relating to the financial year of the transaction shall be used, and previous years' data may only be considered if it 'reveals facts which could have an influence on the determination of transfer prices'; thus, reliance on multiple year data by the assessee without establishing such influence is impermissible.Comparables cannot be rejected solely on the basis of high profitability; the decisive factors include specific characteristics of services, assets employed, risks assumed, contractual terms, market conditions, and the ability to make reasonable adjustments under Rule 10B(3).Functional dissimilarity must be properly examined before excluding a comparable; mere prior inclusion or high profit margins do not preclude reassessment of functional comparability for the relevant year.Bonuses paid to shareholder-employees in their managerial capacity are allowable deductions under Section 36(1)(ii) if not paid in lieu of dividends and not in exact proportion to shareholding, especially where interim dividends were declared. RATIONALE: The legal framework for ALP determination is governed primarily by Section 92C of the Income Tax Act, 1961 and Rule 10B of the Income Tax Rules, 1962, which prescribe methods for ALP determination and criteria for comparability analysis.Rule 10B(2) requires comparability to be judged with reference to functions performed, assets employed, risks assumed, contractual terms, and market conditions; Rule 10B(3) mandates that comparables are acceptable if differences do not materially affect price or profit or can be reasonably adjusted.Rule 10B(4) provides that data for the relevant financial year shall be used, with previous years' data considered only if relevant facts influencing transfer price determination exist; the use of multiple year averages without such justification is contrary to the Rule's mandate.The court recognized the persuasive but non-binding nature of OECD Transfer Pricing Guidelines, emphasizing that Indian statutory provisions and Rules are supreme and must be applied strictly; OECD guidelines may be considered only for interpretative aid when consistent with domestic law.Precedent decisions demonstrate divergent views on exclusion of 'super profit' comparables; however, the court aligned with the principle that exclusion requires specific material differences affecting comparability, not mere profit level disparities.The court remitted the matter to the Dispute Resolution Panel (DRP) for detailed application of Rule 10B(3) to assess whether material differences arising from high profits of certain comparables can be eliminated, and for functional comparability analysis of one disputed comparable.Regarding Section 36(1)(ii) disallowance, the court relied on the absence of proportionality between bonus and shareholding, the managerial capacity of recipients, and the presence of interim dividends to allow the deduction, rejecting revenue's tax avoidance inference.