TNMM on composite transactions, revenue treatment of testing and software costs, and limited remand on depreciation comparables

Where import of raw materials and export of finished goods were closely inter-linked, arm's length pricing was to be determined on a composite basis under TNMM rather than by applying separate methods. Depreciation could be excluded from TNMM margins only where exceptional facts showed a material difference, so the depreciation issue was remitted for fresh examination. Testing fee paid to an associated enterprise was treated as revenue expenditure, not fees for technical services, because it did not make available technical know-how or create an enduring asset. Software expenditure was also held to be revenue in nature because it was incurred for the smooth running of business and did not result in a new capital asset.

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Issues: (i) Whether the Transactional Net Margin Method or a separate Comparable Uncontrolled Price method should govern the arm's length determination for closely linked international transactions of import and export; (ii) whether depreciation should be excluded while computing margins under the Transactional Net Margin Method in the facts of the case; (iii) whether testing fee paid to the associated enterprise was fee for technical services or capital expenditure; (iv) whether software expenditure was capital in nature.

Issue (i): Whether the Transactional Net Margin Method or a separate Comparable Uncontrolled Price method should govern the arm's length determination for closely linked international transactions of import and export.

Analysis: The transactions of import of raw materials and export of finished goods were found to be inter-related and mutually dependent, with the import price directly affecting the export price. In such composite circumstances, testing the transactions separately under different methods was held to be inappropriate. The arm's length price was required to be determined on a consolidated basis by applying the Transactional Net Margin Method to the composite transactions.

Conclusion: The deletion of the transfer pricing adjustment on this aspect was upheld, and the issue was decided against the Revenue.

Issue (ii): Whether depreciation should be excluded while computing margins under the Transactional Net Margin Method in the facts of the case.

Analysis: Depreciation is ordinarily part of operating cost under the Transactional Net Margin Method, but an exception may arise where the assessee demonstrates a substantial and material difference in depreciation because of exceptional facts. The assessee claimed a newly installed state-of-the-art plant, while the comparative position also required consideration of related cost elements such as wages and salary. The matter therefore required fresh examination of the comparative impact of depreciation and allied costs.

Conclusion: The issue was restored to the Assessing Officer and the Transfer Pricing Officer for fresh adjudication, and no final relief was granted on merits at this stage.

Issue (iii): Whether testing fee paid to the associated enterprise was fee for technical services or capital expenditure.

Analysis: The payment was for product testing for quality purposes to meet standards and did not result in transfer of technical knowledge, making available of know-how, acquisition of any enduring advantage, or creation of a new asset. The expenditure was thus revenue in character and not fee for technical services.

Conclusion: The deletion of the disallowance was upheld, and the issue was decided in favour of the assessee.

Issue (iv): Whether software expenditure was capital in nature.

Analysis: The software was incurred for smooth functioning of the business and did not bring into existence any new asset or enduring capital advantage. The expenditure was therefore not capital expenditure.

Conclusion: The deletion of the disallowance was upheld, and the issue was decided in favour of the assessee.

Final Conclusion: The appeal succeeded only to the limited extent of remitting the depreciation issue for reconsideration, while the remaining deletions were sustained.

Ratio Decidendi: Where international transactions are closely linked and inter-dependent, their arm's length price should ordinarily be determined on a composite basis under the most appropriate method, and depreciation may be excluded from TNMM comparisons only in exceptional cases supported by material differences.

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