High Court allows EPF and ESI deductions in tax returns

The Karnataka High Court ruled that employees' contributions towards EPF and ESI, made before the due date for filing income tax returns, are deductible under Section 36(1)(va). In the transfer pricing dispute, the Tribunal upheld the TPO's adjustment, adding income due to a shortfall in international transaction pricing. The Tribunal excluded Persistent Systems Ltd. and remanded Tech Mahindra Ltd. for reconsideration based on related party transactions. Working capital adjustment was allowed, aligning the profit margin with the Arm's Length Price range. The appeal was partly allowed with specific directions, pronounced on 3rd July 2020.

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Issues Involved:
1. Disallowance of employees' contribution towards EPF under Section 36(1)(va).
2. Transfer pricing adjustments and determination of Arm's Length Price (ALP).

Detailed Analysis:

Issue 1: Disallowance of Employees' Contribution towards EPF

The first issue raised by the assessee is whether payments of employees' contribution towards provident fund (PF) and Employees State Insurance (ESI) made after the due date but before the filing of the income return can be disallowed under Section 36(1)(va) of the Income-tax Act, 1961. The Karnataka High Court in CIT Vs. Sabari Enterprises has ruled that such contributions are allowable deductions if paid before the due date for furnishing the return of income under Section 139(1). Consequently, the Tribunal found merit in the assessee's claim and allowed the deduction. This issue, although not raised before the Dispute Resolution Panel (DRP), was deemed permissible to be raised in the second appeal as per the precedent set by Avery Cycle Industries Ltd Vs. CIT.

Issue 2: Transfer Pricing Adjustments and Determination of ALP

The remaining grounds of appeal pertain to the determination of the ALP for international transactions involving software development services rendered by the assessee to its Associated Enterprise (AE) under Section 92 of the Act. The Tribunal noted that the Transactional Net Margin Method (TNMM) was the most appropriate method for determining the ALP, with the Profit Level Indicator (PLI) being the Operating Profit (OP) to Operating Cost (OC) ratio.

The assessee's OP/OC ratio was initially 15.83% but was revised to 12.15% by the Transfer Pricing Officer (TPO) after including foreign exchange loss as part of operating expenditure. The TPO's action was upheld by the DRP and found correct by the Tribunal.

The TPO selected 7 comparable companies and determined the arithmetic mean of their profit margins to be 20.90%. After adjusting for working capital at 5.23%, the adjusted margin was 15.67%. The TPO's computation resulted in an addition of Rs. 74,69,142 to the assessee's income due to a shortfall in the price charged in the international transaction.

The assessee contested the inclusion of certain comparables and the denial of working capital adjustments by the DRP. Specifically, the assessee sought the exclusion of Persistent Systems Ltd. and Tech Mahindra Ltd. and the inclusion of ICRA Techno Analytics and Mindteck (India) Ltd.

Exclusion of Persistent Systems Ltd.

The Tribunal referred to the ITAT Hyderabad Bench's decision in M/s. EPAM Systems (I) P. Ltd. v. ACIT, which excluded Persistent Systems Ltd. due to its involvement in software products and solutions without segmental details. The Tribunal agreed with this precedent and excluded Persistent Systems Ltd.

Exclusion of Tech Mahindra Ltd.

The Tribunal considered the assessee's argument that Tech Mahindra Ltd. had a Related Party Transaction (RPT) ratio of 42.88%, failing the RPT filter applied by the TPO. The Tribunal remanded this issue to the AO/TPO for reconsideration based on the RPT filter.

Working Capital Adjustment

The Tribunal addressed the DRP's denial of working capital adjustment, which the TPO had allowed at 5.23%. Citing the ITAT Bangalore's decision in Huawei Technologies (India) Pvt. Ltd. Vs. DCIT, the Tribunal emphasized the necessity of working capital adjustments to account for differences in time value of money between the tested party and comparables. The Tribunal directed the TPO to allow the working capital adjustment as claimed by the assessee.

Other Comparables

The Tribunal did not consider the exclusion of Larsen & Toubro Infotech Ltd. and the inclusion of ICRA Techno Analytics Ltd. and Mindteck (India) Ltd. because the relief granted regarding working capital adjustment rendered the assessee's profit margin within the ALP range.

Conclusion

The appeal was partly allowed, with specific directions for the exclusion of Persistent Systems Ltd., reconsideration of Tech Mahindra Ltd. based on the RPT filter, and allowance of the working capital adjustment. The Tribunal's decision was pronounced on 3rd July 2020.

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