2018 (4) TMI 1867 - AT - Income Tax

Tribunal Upholds DRP's Transfer Pricing Directions, Emphasizes Consistency

The Tribunal upheld the DRP's directions on all issues, dismissing both the revenue's appeal and the assessee's cross-objections. The TNMM method was ... Transactional net margin method (TNMM) - comparable uncontrolled price (CUP) method - functional aggregation/segregation of international transactions - working capital adjustment in transfer pricing - interest on intercompany receivables (interest forgone) - safe harbour principles for benchmarking - mercantile system of accounting and crystallisation of liabilitiesTransactional net margin method (TNMM) - comparable uncontrolled price (CUP) method - functional aggregation/segregation of international transactions - Whether the TPO was justified in segregating the assessee's accounts into trading and commission segments and applying CUP to commission income instead of applying TNMM on aggregated entity-level financials - HELD THAT: - The Tribunal upheld the Dispute Resolution Panel's finding that the assessee's international transactions and business model for AY 2010-11 were identical to prior years where TNMM was applied. The TPO's segregation, based solely on income without reference to gross profit or costs related to inventory and services, was held to be unreliable in the facts of this case where distribution and commission activities were closely integrated (common management, employees, services such as installation/warranty). Absent compelling reasons to disturb the functional integrity and the consistent application of TNMM in preceding years, discarding TNMM in favour of CUP for the commission segment was not justified. The Tribunal found the DRP's approach to apply TNMM at entity level to be a plausible and safe method and therefore upheld the DRP's direction to the TPO to adopt TNMM on aggregated financials. [Paras 10, 11, 18, 21]TPO's bifurcation and application of CUP to commission income set aside; TNMM to be applied at entity level as directed by the DRP.Working capital adjustment in transfer pricing - Whether the DRP's direction to give working capital adjustment while computing average margins of comparables was warranted - HELD THAT: - The Tribunal agreed with the DRP that adjustments for working capital are relevant to improve comparability because trade receivables, payables and inventory affect interest cost and thereby margins. The DRP's direction that the taxpayer provide reliable data and that the TPO give working capital adjustment (with reference to rule 10B(3) and supporting precedents) was held to be neither illegal nor irregular. The Tribunal declined to interfere with that direction. [Paras 22, 23]Direction to compute working capital adjustment and require taxpayer data upheld.Interest on intercompany receivables (interest forgone) - safe harbour principles for benchmarking - Whether the DRP's direction to compute interest forgone on receivables from AEs and to apply specified benchmark rates was sustainable - HELD THAT: - The DRP accepted that payment terms entitled the assessee to receive payment within 30 days and that delay beyond 30 days in an arm's length situation would warrant a return based on opportunity cost. Although safe harbour rules were not applicable to the year under consideration, the DRP relied on their underlying principle for benchmarking. The Tribunal found no legal or factual infirmity in directing the TPO to verify receivables and compute interest forgone, applying SBI base rate plus specified basis points depending on aggregate receivables, and to bring only net interest income to tax. The direction was upheld. [Paras 24, 25]DRP's direction to compute interest forgone on overdue intercompany receivables using specified benchmark rates and to tax net interest income upheld.Mercantile system of accounting and crystallisation of liabilities - Whether the assessing officer was justified in disallowing travelling expenses as a prior period expense - HELD THAT: - The DRP examined whether the travelling expenditure related to a project for which income was recognised in the later year and whether the liability for the expense had crystallised in the earlier year. The DRP concluded that the travelling expenses accrued and arose in the year in which they were charged and that mere relation of an expense to an earlier transaction does not render it deductible in the earlier year unless the liability had crystallised and was quantifiable then. On those findings the DRP directed deletion of the addition. The Tribunal found this reasoning lawful and declined to interfere. [Paras 26, 27]Addition on account of travelling expenses deleted; DRP's direction to allow the expenses upheld.Whether the assessee's cross-objection required separate adjudication after outcome on principal ground - HELD THAT: - The Tribunal held that in view of its finding on the primary issue (acceptance of TNMM at entity level), the grounds raised in the assessee's cross-objection became infructuous and did not require separate consideration. [Paras 28]Cross-objection dismissed as infructuous.Final Conclusion: The appeals were dismissed. The Tribunal upheld the DRP's directions: to apply TNMM at entity level instead of CUP on segregated segments, to provide and apply working capital adjustments, to compute interest forgone on intercompany receivables using the specified benchmarking approach and to delete the assessing officer's disallowance of travelling expenses; the assessee's cross-objection was dismissed as infructuous. Issues Involved:1. Rejection of TNMM as the most appropriate method for computing the arm's length price of international transactions.2. Denial of working capital adjustment while determining average margins of comparables.3. Charging of interest on receivables from AEs.4. Disallowance of travelling expenses as prior period expense.Detailed Analysis:1. Rejection of TNMM as the Most Appropriate Method:The assessee adopted the TNMM method to benchmark international transactions, selecting five comparables with an average margin of 7.44% against the taxpayer's margin of 13.18%. The TPO rejected this analysis, segregating financials into distribution and commission segments and applying the CUP method for commission income. The DRP, however, directed the TPO to apply TNMM, citing consistency with previous years where the business model and FAR profile remained unchanged. The Tribunal upheld the DRP's direction, emphasizing the need for consistency and rejecting the TPO's approach of bifurcating financials without compelling reasons.2. Denial of Working Capital Adjustment:The DRP directed the TPO to provide a working capital adjustment to improve comparability, referencing rule 10B(3) and decisions in Mentor Graphics, Sony India, and Philips Software. The Tribunal found no illegality in this direction, recognizing the impact of trade receivables, payables, and inventory on margins, and upheld the DRP's decision.3. Charging of Interest on Receivables:The DRP instructed the TPO to compute interest on receivables outstanding beyond 30 days, applying SBI base rates plus basis points depending on the aggregate amount of receivables. The Tribunal found the DRP's reasoning, based on opportunity cost and safe harbor principles, to be neither illegal nor irregular and upheld the direction.4. Disallowance of Travelling Expenses:The DRP found that the travelling expenses, though incurred in the previous year, were related to a project whose revenue was recognized in the current year. Citing the Gujarat High Court's decision in Saurashtra Cement, the DRP allowed the expenses, reasoning that liability crystallized in the current year. The Tribunal agreed with this legal reasoning and upheld the DRP's direction to delete the disallowance.Conclusion:The Tribunal dismissed both the revenue's appeal and the assessee's cross-objections, upholding the DRP's directions on all issues. The consistent application of TNMM, provision of working capital adjustments, computation of interest on receivables, and allowance of travelling expenses were all affirmed as legally sound and appropriate.