2023 (6) TMI 1493 - AT - Income Tax

ITAT upholds capacity utilization adjustment in transfer pricing for start-up phase under Section 92C

Deputy Commissioner of Income-tax, Circle-1 (1), Kolkata Versus Kyocera CTC Precision Tools Pvt. Ltd.

Deputy Commissioner of Income-tax, Circle-1 (1), Kolkata Versus Kyocera CTC Precision Tools Pvt. Ltd. - TMI 1. ISSUES PRESENTED and CONSIDERED 1. Whether the adjustment made by the assessee for capacity utilisation in benchmarking international transactions under the Transactional Net Margin Method (TNMM) is permissible and justified. 2. Whether the deletion of the Transfer Pricing Officer's (TPO) adjustment on account of capacity under-utilisation by the Commissioner of Income Tax (Appeals) [CIT(A)] is legally sustainable. 3. Whether there exists any statutory or regulatory embargo under the Income-tax Act, 1961 or Income-tax Rules, 1962 (specifically Rule 10B(1)(e)(iii)) against making capacity utilisation adjustments in determining Arm's Length Price (ALP). 4. Whether the absence of relevant financial data of comparable companies for capacity utilisation adjustment justifies disallowance of such adjustment. 5. The appropriate method and approach for making capacity utilisation adjustment in transfer pricing benchmarking. 2. ISSUE-WISE DETAILED ANALYSIS Issue 1 & 2: Permissibility and Justification of Capacity Utilisation Adjustment and Deletion of TPO's Adjustment by CIT(A) Relevant Legal Framework and Precedents: - Section 92C of the Income-tax Act, 1961 mandates determination of ALP using the Most Appropriate Method (MAM), here TNMM. - Rule 10B(1)(e)(iii) of the Income-tax Rules, 1962 requires adjustment of net profit margin of comparables to account for differences materially affecting net profit margin. - Judicial precedents recognize capacity utilisation as a factor materially affecting profitability and permit adjustments for it. Notable cases include: High Court of Karnataka in Pr. Commissioner of Income Tax-7 & Anr. Vs. M/s. Sami Labs: Adjustment allowed for cost attributable to idle capacity. Bombay High Court in Commissioner of Income Tax-8 Vs. Petro Araldite Pvt. Ltd.: Fixed overheads remain constant irrespective of capacity utilisation, affecting profit margins. ITAT Kolkata in Witzenmann India Pvt. Ltd. Vs. DCIT: Capacity utilisation adjustment is necessary to avoid distorted profit margins due to under-absorption of fixed costs. Court's Interpretation and Reasoning: - Capacity utilisation represents the extent to which installed productive capacity is used. Lower utilisation leads to under-absorption of fixed costs, thereby reducing profitability. - The assessee was in its start-up phase with 34% capacity utilisation compared to industry average of 73.19%. Fixed costs incurred remain largely constant regardless of production volume. - Without adjustment for capacity utilisation, the assessee's margins would appear artificially depressed and not comparable to established companies operating at higher utilisation. - CIT(A) analyzed three aspects: commercial effect of under-utilisation, judicial sanction for such adjustment, and absence of statutory embargo against it. - The Tribunal concurred with CIT(A) that capacity utilisation adjustment is an integral factor in comparability analysis under TNMM. Key Evidence and Findings: - Industry reports from RBI and FICCI established average capacity utilisation at ~73% for manufacturing and automotive sectors. - The assessee's capacity utilisation was undisputedly 34% during the relevant year. - The assessee's transfer pricing study included capacity utilisation adjustment, raising its Net Cost Plus (NCP) margin from median 5.16% to adjusted 11.66%. - Comparable companies had earlier commencement dates and higher utilisation, supporting the need for adjustment. Application of Law to Facts: - Rule 10B(1)(e)(iii) mandates adjustment of net profit margins for material differences affecting profitability, which includes capacity utilisation. - Judicial precedents affirm that capacity utilisation materially affects profit margins and must be considered in benchmarking. - The assessee's adjustment methodology, based on fixed cost adjustment or hypothetical revenue/variable cost adjustment, is consistent with accepted approaches. Treatment of Competing Arguments: - Revenue argued absence of relevant financial data of comparables for capacity utilisation adjustment and lack of standardized method under the Act. - Tribunal noted that where data on comparables is unavailable, TPO/AO has power under Section 133(6) to obtain such information directly from comparables. - The assessee provided detailed computations and relied on recognized industry data and judicial pronouncements. - The Tribunal found no statutory embargo on capacity utilisation adjustment and rejected Revenue's contention that adjustment without comparables' data is impermissible. Conclusions: - Capacity utilisation adjustment is permissible, necessary, and supported by statutory provisions, judicial precedents, and commercial realities. - The deletion of TPO's adjustment by CIT(A) was justified as the assessee's adjustment reflected a realistic and comparable profit margin. - The appeal against deletion of capacity utilisation adjustment is dismissed. Issue 3: Statutory and Regulatory Embargo on Capacity Utilisation Adjustment Relevant Legal Framework and Precedents: - Rule 10B(1)(e)(iii) of Income-tax Rules, 1962 explicitly requires adjustment of net profit margin of comparables to eliminate material effects of differences between transactions or enterprises. - ICAI Guidance Note on Report under Section 92E lists capacity utilisation differences as a relevant factor affecting net margins. - OECD Transfer Pricing Guidelines recognize capacity utilisation differences as impacting absorption of fixed costs and net margins, especially under TNMM. Court's Interpretation and Reasoning: - The Rule mandates adjustments for material differences affecting net profit margin, with capacity utilisation being a recognized such difference. - No express prohibition or embargo exists in the Act or Rules against making capacity utilisation adjustments. - Judicial authorities have sanctioned and mandated factoring capacity utilisation differences to achieve arm's length comparability. Key Evidence and Findings: - The Rule's language ('adjusted to take into account the differences... which could materially affect the amount of net profit margin') includes capacity utilisation as a material difference. - ICAI and OECD guidance further corroborate the statutory interpretation. Application of Law to Facts: - The Tribunal found that capacity utilisation adjustment falls squarely within the ambit of permissible adjustments under Rule 10B(1)(e)(iii). Treatment of Competing Arguments: - Revenue's claim of non-existence of standardized method does not amount to embargo on adjustment itself. - The Tribunal noted that the methodology adopted by the assessee is reasonable and accepted in judicial precedents. Conclusions: - There is no statutory or regulatory embargo on capacity utilisation adjustment under the Income-tax Act or Rules. - Such adjustment is consistent with the legislative intent and regulatory framework governing transfer pricing. Issue 4: Absence of Relevant Financial Data of Comparable Companies Relevant Legal Framework and Precedents: - Section 133(6) of the Income-tax Act empowers the TPO/AO to call for information from comparable companies to obtain necessary data. - Judicial precedents (e.g., ITAT Mumbai in CIT v. Kiara Jewellery) direct the TPO/AO to procure capacity utilisation data of comparables if not publicly available. Court's Interpretation and Reasoning: - Lack of publicly available data on comparables' capacity utilisation does not preclude making adjustment. - The TPO/AO must exercise statutory powers to obtain such data to enable accurate benchmarking. - The matter was remitted to TPO/AO for fresh consideration after obtaining necessary data and providing opportunity of hearing to the assessee. Key Evidence and Findings: - The assessee's adjustment was based on available industry data and reasonable assumptions. - The Tribunal directed TPO/AO to collect data on capacity utilisation and working capital levels from comparables under Section 133(6) where unavailable. Application of Law to Facts: - The absence of comparable data does not justify disallowance of adjustment but requires data collection to enable proper adjustment. Treatment of Competing Arguments: - Revenue's argument that adjustment is not verifiable without comparable data is addressed by statutory powers to obtain such data. Conclusions: - TPO/AO is directed to obtain relevant data from comparables and decide capacity utilisation adjustment afresh. - The adjustment is not to be rejected solely for lack of comparable data in public domain. Issue 5: Appropriate Method and Approach for Capacity Utilisation Adjustment Relevant Legal Framework and Precedents: - Rule 10B(1)(e)(iii) requires adjustments to net profit margins for material differences. - Judicial precedents and OECD guidelines recognize various approaches for capacity utilisation adjustment. Court's Interpretation and Reasoning: - Three approaches identified for capacity utilisation adjustment: Adjust fixed costs of tested party keeping sales and variable costs unchanged. Adjust sales and variable costs hypothetically to optimum utilisation keeping fixed costs constant. Adjust profit margin of comparables by aligning depreciation absorption rates. - Due to unavailability of comparables' capacity utilisation data, adjusting tested party's fixed costs (Approach 1) is the plausible method. - Variable costs vary directly with production and require no adjustment; fixed costs remain constant and require adjustment. Key Evidence and Findings: - Assessee's computations under both fixed cost adjustment and hypothetical revenue/variable cost adjustment yielded consistent adjusted margins. - Adjusted NCP margin after capacity utilisation adjustment was 11.66%, comparable with Indian comparables. Application of Law to Facts: - The methodology adopted by the assessee is reasonable, consistent with judicial guidance and regulatory framework. Treatment of Competing Arguments: - Revenue's objection on lack of standardised method is addressed by acceptance of reasonable and documented approaches. Conclusions: - Capacity utilisation adjustment by adjusting fixed costs of the tested party is appropriate where comparable data is unavailable. - The assessee's approach is accepted as valid for benchmarking under TNMM.