ITAT rules depreciation must be included in operating costs for transfer pricing TNMM calculations under section 92C

The ITAT Pune ruled on transfer pricing adjustments under TNMM method. The tribunal held that depreciation should be included in operating costs when calculating PBIT/Sales ratio, rejecting the assessee's argument for PBDIT/Sales. No adjustment was allowed for depreciation differences between companies, as higher depreciation typically correlates with lower repair costs. Federal-Mogul Bearings India Ltd. was properly excluded from comparables due to functional differences - it engaged in both trading and manufacturing without discernible segmental information. The tribunal upheld granting +/-5% margin for ALP determination under section 92C(2) proviso. While accepting Revenue's ground regarding certain comparable companies' inclusion, no additional transfer pricing adjustment resulted as the assessee's profit margin remained within permissible range.

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Issues Involved:
1. Adoption of PBIT/Sales instead of PBDIT/Sales for benchmarking international transactions under the Manufacturing segment.
2. Adjustment on account of higher depreciation rates and under-utilization of capacity.
3. Exclusion of Federal-Mogul Bearings India Ltd. (FMBIL) from the list of comparables.
4. Grant of +/-5% margin in determining the Arm’s Length Price (ALP).
5. Inclusion of certain companies in the list of comparables for the Trading segment.

Issue-wise Detailed Analysis:

1. Adoption of PBIT/Sales instead of PBDIT/Sales for Benchmarking International Transactions:
The assessee employed the Transactional Net Marginal Method (TNMM) with PBDIT/Sales as the Profit Level Indicator (PLI) to benchmark its international transactions under the Manufacturing segment. The TPO substituted PBDIT/Sales with PBIT/Sales, including depreciation in the total operating costs. The Tribunal upheld this substitution, reasoning that depreciation is an integral part of operating costs. The Tribunal emphasized that "depreciation is an inseparable and an integral part of the operating costs," aligning with the Hon’ble Bombay High Court’s decision in CIT Vs. Welspun Zucchi Textiles Ltd.

2. Adjustment on Account of Higher Depreciation Rates and Under-utilization of Capacity:
The assessee argued for adjustments due to higher depreciation rates and under-utilization of capacity. The TPO allowed adjustments for higher depreciation rates and under-utilization of capacity but denied further adjustments for excessive depreciation compared to comparables. The Tribunal agreed, stating that no further adjustment is permissible as the overall operating profit margin encompasses the cumulative effect of all operating expenses and incomes.

3. Exclusion of Federal-Mogul Bearings India Ltd. (FMBIL) from the List of Comparables:
The TPO excluded FMBIL from the comparables due to its diversified activities, including manufacturing of Powder and Aluminum Tins, and significant Related Party Transactions (RPTs). The Tribunal upheld this exclusion, highlighting the importance of functional similarity in comparability analysis. It noted that FMBIL’s diversified activities and lack of segmental information made it incomparable to the assessee, which is solely engaged in manufacturing bearings.

4. Grant of +/-5% Margin in Determining the ALP:
The Revenue contested the grant of a +/-5% margin in determining the ALP. The Tribunal referred to the second proviso to section 92C(2), which allows for such a margin if the variation between the ALP and the transaction price does not exceed the specified margin. The Tribunal upheld the CIT(A)’s decision to grant this margin, noting its applicability to the assessment year 2009-10 as clarified by the Finance (No.2) Act, 2009.

5. Inclusion of Certain Companies in the List of Comparables for the Trading Segment:
The Revenue challenged the inclusion of certain companies in the list of comparables for the Trading segment. The Tribunal noted that even if the contested companies were excluded, the assessee’s profit margin would still fall within the permissible +/-5% range. Consequently, while technically accepting the Revenue’s ground, the Tribunal concluded that it would not lead to any transfer pricing addition under the Trading segment.

Conclusion:
The Tribunal dismissed the assessee’s appeal and partly dismissed the Revenue’s appeal on merits, with part of it becoming academic. The Tribunal upheld the TPO’s approach to including depreciation in operating costs, denied further adjustments for higher depreciation, and supported the exclusion of FMBIL from comparables. The decision to grant a +/-5% margin in determining the ALP was also upheld.

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