Transfer pricing rules excluded for branch-head office merger; comparable filters adjusted and related-party filters clarified; idle-capacity claim denied

ITAT DELHI - AT held that transfer pricing provisions do not apply to transactions between the Indian head office and its Canadian branch because branch income and balance-sheet items were merged with the head office; the impugned order was set aside pro tanto. The TPO was upheld in applying a size-based comparable filter; exclusion for companies with export revenue under 25% was modified to a 30% threshold by agreement. Related-party transaction filtering must treat sales and purchases separately. Companies with persistent losses (not merely diminishing revenues) are excluded. Companies with high onsite revenue may be included subject to verification of branch onsite/offsite break-up. Claim for idle-capacity adjustment was rejected.

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Issues Involved:
1. Determination of Arm’s Length Price (ALP) for transactions between the Indian head office and its branch office in Canada.
2. Transfer pricing adjustment for 'Software development services' provided to an associated enterprise in the USA.
3. Application of specific filters by the Transfer Pricing Officer (TPO) in selecting comparable companies.
4. Adjustment on account of idle capacity.

Issue-wise Detailed Analysis:

1. Determination of Arm’s Length Price (ALP) for transactions between the Indian head office and its branch office in Canada:
The primary issue in this appeal is whether transactions between an Indian head office and its branch office in Canada should be subject to transfer pricing adjustments. The tribunal noted that transactions between a head office and its branch office do not constitute 'international transactions' as per Section 92B(1) of the Income-tax Act, 1961 because a branch office is not a separate enterprise. The principle of mutuality, supported by several judgments, including Sir Kikabhai Prem Chand VS CIT (1953) and Betts Hartley Huett & Co. Ltd. VS CIT (1979), implies that no profit or loss can arise from transactions with oneself. Furthermore, the tribunal explained that any profit earned by the head office from the branch office would be offset by the corresponding expense in the branch office, making such transactions tax neutral. Consequently, the tribunal concluded that transfer pricing provisions do not apply to transactions between the Indian head office and its branch office in Canada.

2. Transfer pricing adjustment for 'Software development services' provided to an associated enterprise in the USA:
The assessee contested a transfer pricing adjustment of Rs. 2,59,26,400/- for software development services provided to its associated enterprise, Aithent Inc., USA. The TPO had used the Transactional Net Margin Method (TNMM) and selected comparables after applying specific filters. The tribunal agreed with the filters applied by the TPO but remitted the matter back to the TPO/AO for reconsideration of the comparability of companies based on the tribunal's observations.

3. Application of specific filters by the Transfer Pricing Officer (TPO) in selecting comparable companies:
The tribunal addressed several filters applied by the TPO in selecting comparable companies:
- Revenue Filter: The tribunal upheld the TPO's exclusion of companies with software development service revenue less than Rs. 1 crore, rejecting the assessee's argument for an upper limit on turnover.
- Export Sales Filter: The tribunal found the TPO's filter of excluding companies with less than 25% export sales inappropriate since it would exclude companies similarly placed as the assessee. Both parties agreed to apply a filter excluding companies with export sales of more than 30% of total revenue.
- Related Party Transactions (RPT) Filter: The tribunal directed the TPO to segregate RPTs of purchases and sales separately instead of combining them, ensuring the percentage of RPTs is correctly calculated.
- Diminishing Revenues/Persistent Losses Filter: The tribunal held that companies with diminishing revenues should not be excluded, but companies with persistent losses should be.
- Onsite Income Filter: The tribunal directed the TPO/AO to verify the revenue break-up of the branch office in Canada to determine if the filter excluding companies with more than 75% onsite income should be applied.

4. Adjustment on account of idle capacity:
The assessee sought a reduction in operating costs due to 42% idle capacity of its employees. The tribunal rejected this request, stating that the TNMM method does not provide for adjusting the assessee’s profit margin. Adjustments could only be considered if the assessee demonstrated that comparable companies had more under-utilization of labor, which the assessee failed to do. Consequently, the tribunal upheld the authorities' decision on this issue.

Conclusion:
The appeal was allowed for statistical purposes, with the tribunal remitting the matter back to the TPO/AO for reconsideration of comparables based on the tribunal's observations and directions. The order was pronounced in the open court on 21.09.2016.

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