2023 (2) TMI 1419 - AT - Income Tax

AO/TPO to redecide transfer pricing and tax adjustments: capacity-utilisation, customs, freight, FX, working capital, royalties, warranty

M/s. Continental Automotive Components India Pvt. Ltd. Versus The Deputy Commissioner of Income Tax, Circle 2 (1) (1), Bengaluru

ITAT BANGALORE - AT remitted multiple transfer pricing and tax issues to the AO/TPO for fresh decision after affording the assessee opportunity of ... TP Adjustment - adjustment for under-utilization of capacity - HELD THAT:- It is appropriate to remit the issue relating to adjustment on account of capacity utilisation of the assessee to the file of the AO/TPO for deciding the same afresh keeping in view the OECD guidelines. If the exact details of capacity utilisation of comparable companies are not available in the public domain, the AOITPO is directed to obtain the same directly from the comparable companies and decide the issue afresh, after affording opportunity of being heard to the assessee. Accordingly, this issue is remitted to the AO/TPO. Adjustment for custom duty - Customs duty was to be eliminated from the comparable price also to arrive at correct PLI. Accordingly, we remit the issue to the file of AO for fresh consideration. Adjustment for foreign exchange fluctuations - As decided in own case for AY 2012-13 we direct the TPO to provide considerable exchange fluctuation adjustment while determining the ALP. Accordingly, this issue is remitted to the file of the TPO for determining the ALP after considering the above three components i.e. customs duty adjustment, air freight adjustment and foreign exchange fluctuation adjustment. Depreciation adjustment - DRP in its directions held that depreciation adjustment is related to the capacity adjustment and can be granted only in the initial years and that such high investments are observed not only for the Assessee but in the entire industry - HELD THAT:- We notice that the coordinate bench in assessee’s own case [2022 (3) TMI 1522 - ITAT BANGALORE] as held adjustment on account of underutilization of capacity will sufficiently take care of the depreciation adjustment and no separate adjustment is required to be granted on account of difference in quantum of depreciation vis-a-vis difference in capacity utilization and cost of fixed assets. We hold and direct accordingly. The decisions cited are all in the context of capacity utilization and cannot be extended to grant of depreciation adjustment. Comparable selection - Deselection of companies as functionally dissimilar. Restrict the adjustment on account of determination of ALP only to that part of the transaction with AE and not the entire value of the manufacturing segment. It is ordered accordingly. Payment of royalty fee - TPO determined an adjustment in respect of the payment of royalty by holding that (i) the Assessee had not demonstrated receipt of the services, or benefit there from; and (ii) the services are duplicative in nature. We also notice that the assessee has placed the relevant documents in terms of agreement etc., in this connection before the lower authorities and that the same have not been examined. We also see merit in the argument of the ld. AR that the AO and the DRP, while making an adjustment on the corporate tax front, have categorically held that the Assessee has received the services having enduring benefit thereby disallowing the same expenses u/s. 37 also and therefore revenue cannot take a different stand for TP adjustment. We further notice that the TPO has arrived at the ALP as NIL without doing any bench marking merely based on the ground that the assessee has not substantiated having received the services without examining the documents submitted. In view of this we remit the issue back to the TPO for fresh examination. Comparable selection for SWD SERVICES SEGMENT -It is important that the functions of the assessee be compared with that of these companies based on facts. Further the Ld AR submitted that most of these comparables have been excluded by the DRP in assessee’s own case in the subsequent years based on these criteria. In view of this we remit the issue of exclusion of all the companies viz., Rheal Software Pvt. Ltd., Inteq Software Pvt. Ltd., Larsen & Toubro Infotech Ltd., Nihilent Ltd, Persistent Systems Ltd., Infobeans Technologies Ltd., Aspire Systems (India) Pvt. Ltd., Infosys Ltd., Cybage Software Pvt. Ltd., and Thirdware Solution Ltd., back to the AO/TPO to examine the comparability considering the functionality of the assessee. Maveric Systems Ltd - The reason for exclusion as stated by the DRP is that the company does not feature in the search matrix of the TPO, whereas the contention of the ld. AR is that the company satisfies all filter. We therefore respectfully following the decision of the coordinate bench in assessee’s own case remit the issue of inclusion of this company to TPO for fresh consideration. Akshay Software Technologies Ltd., Sasken Communication Technologies Ltd - We remit the issue of inclusion of Akshay back to the TPO for examination afresh after giving a reasonable opportunity of being heard to the assessee. Ace Software Exports Ltd - DRP has rejected the inclusion for the reason that the assessee did not propose the inclusion of this company during TP proceedings and that it is involved in ITES services. However it is the submission of the ld. AR that the company is engaged in IT services such computer programming, consultancy and related activities. We are therefore of the considered view that the comparability and inclusion of this company needs to be looked afresh for the year under consideration based on examination of facts. Minvesta Infotech Ltd company was rejected by the TPO for the reason that its data was not available in the public domain and was upheld by the DRP for the reason that it follows a different financial year - As we are not in agreement with the decision of the lower authorities to exclude Minvesta Infotech Ltd only on the basis that the company fails different financial year filter. We therefore remit the issue back to the AO/TPO to examine the relevant financial data from which the details can be extrapolated for the purpose of comparison and accordingly decide the inclusion of the company after giving a reasonable opportunity of being heard to the assessee. Evoke Technologies Ltd. - We remit the comparables back to the Ld.AO/TPO for fresh consideration after giving a reasonable opportunity of being heard to the assessee. Agilysis IT Services India Pvt. Ltd rejected for the reason that the RPT details are not available - The fact whether the assessee had any related party transaction during the year under consideration has not been properly verified by the TPO. Further the DRP upheld the exclusion entirely for a different reason stating the company is not featuring in the search matrix of the TPO. We therefore remit this issue back to the AO/TPO to verify the facts pertaining to the comparable afresh. Sagarsoft India Ltd. - Reason for not including the company is that it fails 75% service revenue filter, and that it did not feature in the search matrix of the TPO. Therefore respectfully following the above decision of coordinate bench we remit the issue back to the AO/TPO for fresh consideration. Isummation Technologies Pvt. Ltd., DCIS Dot Com Solutions Pvt. Ltd.,Batchmaster Software Pvt. Ltd - These companies have not been included in the comparable on the reason that these companies were not appeared in TPO search matrix and documentation was available on this comparable. In our opinion, it is appropriate to remit this issue to the file of AO to consider it afresh to see whether all the filters applied by the TPO is satisfied. Non grant of Working Capital adjustment by the TPO -Working capital adjustment is to be allowed as per actuals, after considering the decisions rendered in this order on the exclusion/inclusion of comparable companies out of/into the final set of comparables. The TPO/ AO are accordingly directed. Disallowance of provision for warranty - claim made by the Assessee that the method followed for creating provision for anticipated liability on account of warranty stands vindicated by the fact that the actual liability on account of warranty expenses is always on the higher side - HELD THAT:- The reasons given by the DRP for not accepting the claim of the Assessee is that the provision is created as a percentage of sale, ignoring the fact that past experience is also the basis for creation of provision for warranty. We are therefore of the view that the provision for warranty has to be allowed as a deduction, as the provision created satisfies the requirements for claiming provision as a liability, as laid down in the judicial precedents referred to above. We hold and order accordingly and allow the relevant ground of appeal of the Assessee. Nature of expenses - payment of royalty to make use of know-how and technology - AO has treated the expenditure as capital in nature for the reason that the assessee has not produced proper evidence of the nature of expenditure and the nomenclature used is R&D expenses. We further notice that the various clauses of the agreement supporting the claim of the assessee that the payment made is towards royalty have not been examined by the AO though it is submitted by the ld. AR that these agreements were submitted before the lower authorities. In the light of this discussion we are of the considered view that the issue should be remitted back to the AO to examine the issue afresh based on the agreements and other evidences submitted by the assessee. We also direct the AO to keep in mind the ratio laid down in the case of Luwa India Ltd. [2011 (11) TMI 515 - KARNATAKA HIGH COURT] while examining the case facts in assessee’s case and decide accordingly ISSUES PRESENTED AND CONSIDERED 1. Whether the Transfer Pricing Officer's (TPO) determination of an entity-level TP adjustment for the manufacturing segment (instead of restricting adjustment to the portion attributable to international transactions with Associated Enterprises (AEs)) is permissible under Chapter X of the Income-tax Act. 2. Whether adjustments to the tested party's operating cost (rather than only to comparables) are permissible and, if so, whether specific adjustments claimed - for under-utilisation of capacity, customs duty, foreign-exchange fluctuations and depreciation - were correctly disallowed by the TPO/DRP. 3. Whether certain companies included by the TPO as comparables are functionally comparable (and thus admissible), and conversely whether certain companies excluded should have been included; and whether the TPO properly computed the ALP after accepting some comparables but not using them in computation. 4. Whether the payment characterized as 'royalty' (and separately as technical know-how) is a genuine international transaction for which an arm's-length price (ALP) can be benchmarked, or whether it should be treated as NIL under CUP without proper benchmarking; and whether the royalty is integral to manufacturing and should be benchmarked in aggregate with other manufacturing transactions. 5. Whether the Transaction Net Margin Method (TNMM) application and selection/filtering of comparables for the SWD (software development) services segment by the TPO (35th percentile/median approach and replacement of assessee's comparables) was appropriate. 6. Whether matters requiring factual/material verification should be remitted to the TPO/AO for fresh adjudication consistent with Tribunal precedent and OECD guidelines. ISSUE-WISE DETAILED ANALYSIS Issue 1 - Scope of TP adjustment: Entity-level adjustment v. restriction to international transactions Legal framework: Chapter X (Sections 92/92B/92C) mandates computation of income arising from an international transaction at arm's length price; ALP determination methods are applicable to international transactions with AEs only. Precedent treatment: Tribunal and High Court decisions referred to (Thyssen Krupp, IKA, Kirloskar Toyota etc.) hold that ALP determination/adjustment must be confined to the international transactions with AEs and not applied indiscriminately at entity level unless the ALP computation itself is applied only to the AE transactions. Interpretation and reasoning: The Tribunal observes that the statutory scheme contemplates redetermination of consideration only in respect of international transactions between associated enterprises; therefore, an addition computed on the entity level (i.e., on total segment revenues/costs) without restricting it to the AE portion is beyond the scope of Chapter X. The Tribunal directs that the adjustment be restricted to the portion attributable to transactions with AEs and remits accordingly to AO/TPO. Ratio vs. Obiter: Ratio - ALP/TP adjustment must be restricted to AE transactions; entity-level recharacterisation beyond AE transactions is impermissible under Chapter X. Conclusion embodied in orders remitting computation to AE portion is binding on the facts. Conclusion: Adjustment must be restricted to the international transactions with AEs; the matter is directed back to the AO/TPO for recomputation limited to AE transaction values. Issue 2 - Permissibility and quantification of specific adjustments to operating cost (capacity under-utilisation, customs duty, forex fluctuation, depreciation) Legal framework: Rule 10B(1)(e) and sub-rule (3) permit comparability adjustments to eliminate differences that materially affect net profit margins; adjustments must be 'reasonable and accurate' per rules and OECD guidance. Precedent treatment: Tribunal decisions (Haworth India, Gates Unitta, Skoda Auto, Demag Cranes and subsequent coordinate bench orders in assessee's earlier years) recognize that adjustments for factors like import content, customs duty and forex may be permissible where differences are material and can be credibly quantified; capacity-utilisation adjustments may be allowed where reliable data exists; depreciation adjustments are generally to be subsumed within capacity-utilisation adjustments rather than granted separately. Interpretation and reasoning: The Tribunal accepts that Rule 10B allows adjustments to eliminate material differences and that such adjustments may be made in the hands of the tested party where reliable data for comparables is unavailable. However, grant of adjustments is fact-specific and requires credible evidence. Applying coordinate-bench precedent, the Tribunal: (a) remands capacity-utilisation claim to AO/TPO for fresh consideration (directing AO/TPO to obtain comparables' capacity data under section 133(6) if not publicly available and to apply OECD guidance); (b) remands customs duty claim for re-examination following prior coordinate bench guidance that customs duty may be eliminated/adjusted where import content is necessitated by circumstances beyond the tested party's commercial choice; (c) remands forex fluctuation claim, following precedent that forex gains/losses may be excluded from operating income/expenses for ALP determination where they materially distort margins; (d) holds that separate depreciation adjustment is not warranted where capacity-utilisation adjustment adequately addresses fixed cost recovery differences (following coordinate bench holding that depreciation differences flow from capacity differences). Ratio vs. Obiter: Ratio - adjustments under Rule 10B are permissible if reasonably accurate and supported by evidence; capacity, customs and forex adjustments can be remitted for factual verification. Depreciation adjustment is generally not a standalone adjustment where capacity is addressed. These are applied as binding directions on the facts. Conclusion: All four claimed adjustments require fresh factual consideration by AO/TPO - capacity, customs and forex are remitted for re-examination consistent with Tribunal precedent and OECD guidelines; depreciation adjustment is denied as a separate head but capacity adjustment remand may address fixed cost differences. Issue 3 - Selection/inclusion/exclusion and treatment of comparables; use of accepted comparables in ALP computation Legal framework: Rule 10B(2) prescribes comparability criteria - functions, assets, risks, contractual terms, property characteristics and business models; comparables must satisfy filters and comparable characteristics. Precedent treatment: Coordinate bench decisions emphasize narrow search for functionally similar comparables (e.g., electrical/electronic component manufacturers versus mechanical parts manufacturers), and allow exclusion where specific property characteristics, presence of intangibles or R&D materially differ. Interpretation and reasoning: The Tribunal examined contested comparables: several companies manufacturing mainly mechanical components (non-electrical) or with significant R&D/intangible presence were functionally dissimilar to a manufacturer of electrical/electronic automotive components; where the TPO previously excluded certain companies in other assessment years, the Tribunal directed reconsideration rather than automatic acceptance or rejection. The Tribunal found instances where the TPO had accepted certain comparables but did not include them in ALP computation and directed the TPO to recompute ALP consistently. For a set of contested comparables the Tribunal remitted issues to the TPO to apply the comparative criteria and the ratio from earlier coordinate-bench decisions, after affording the assessee opportunity to be heard. Ratio vs. Obiter: Ratio - comparables must be functionally similar; presence of R&D/intangible assets and different product characteristics justify exclusion. Where TPO accepts comparables, it must give effect to that acceptance in computation. Directives to re-examine and recompute are operative conclusions. Conclusion: TPO/AO to re-examine inclusion/exclusion of specific comparables, to exclude those functionally dissimilar (as per coordinate bench ratios), to include previously accepted comparables where no factual change exists, and to recompute ALP using the accepted comparable set. Issue 4 - Benchmarking/payments characterized as royalty and technical know-how: genuineness, receipt of benefit and ALP determination Legal framework: International transactions for royalties/technical services require benchmarking under Chapter X; Rule 10D and arm's-length methods apply; revenue must examine existence, nature and quantification of services and benefits. Precedent treatment: Authorities require evidence of receipt, quantification and non-duplication; ad-hoc treatment (treating ALP as NIL without benchmarking or without examining evidence) is impermissible; where services are integral to manufacturing, aggregation or appropriate framing of transaction may be required (Avery Dennison, Cummins cited for principle that payments integral to manufacturing may be benchmarked as part of aggregate). Interpretation and reasoning: The TPO treated the royalty payment as NIL under CUP on conclusion of duplicity and lack of substantiation. The Tribunal found that documents evidencing agreements, technical drawings, manuals, IP access and other communications were on record but not examined by the TPO; also, the AO/DRP on corporate tax side had acknowledged enduring benefit. The Tribunal held that arriving at NIL without performing required benchmarking and without examining evidentiary material was unjustified. It remitted the matter to the TPO for fresh examination of documents and determination of ALP in accordance with law (including consideration whether the royalty is integral to manufacturing and should be benchmarked in aggregate), and directed application of rule-based procedure rather than ad hoc nullification. Ratio vs. Obiter: Ratio - revenue cannot treat payments as NIL without following rule-based benchmarking and without examining evidence; where documentary evidence exists of services and benefits, matter must be re-assessed by TPO. Conclusion to remit is binding on the facts. Conclusion: TP adjustment in relation to royalty/technical know-how is remitted to the TPO for fresh examination of evidence and ALP determination under applicable rules; ad-hoc NIL treatment is not sustained. Issue 5 - TNMM application and comparables selection for SWD services segment (percentile/median approach) Legal framework: TNMM per Rule 10B(1)(e) requires selection of appropriate PLI and a comparable set; bench-marking commonly uses percentiles or median depending on the tested party's characteristics and distribution of comparables. Precedent treatment: The Tribunal reviews whether the TPO's replacement of the assessee's comparables and choice of percentile is justified by the comparability filters and reliable public data. Interpretation and reasoning: The assessee chose OP/OC as PLI and proposed a set of comparables yielding a PLI of 5.81%; the TPO rejected most and supplied a revised set with markedly higher margins and computed ALP using 35th percentile/median. The record shows dispute over acceptability of comparables and filter application; given factual disputes over comparability and filters, the Tribunal's general practice (as elsewhere in the order) is to require TPO to re-consider comparable selection and bench-marking applying Rule 10B criteria and to afford opportunity of hearing. (The order records computations and differing sets but directs re-examination where required.) Ratio vs. Obiter: Procedural ratio - TPO must apply comparability filters consistently and explain replacement/rejection of assessee's comparables; percentile selection must be justified on record. Conclusion is operative as to need for reasoned re-examination. Conclusion: The TPO's selection/filtering and percentile application for SWD segment require reasoned re-examination; the Tribunal directs AO/TPO to re-consider comparables and benchmarking consistent with Rule 10B and to apply explained percentile selection after affording hearing. Issue 6 - Remittal where factual verification is necessary Legal framework & precedent: Where comparability, specific factual quantification or non-public data is necessary, Tribunal and coordinate benches have directed remittal to AO/TPO with directions to obtain information (including under section 133(6)) and apply OECD guidelines. Interpretation and reasoning: The Tribunal repeatedly notes gaps in public data (e.g., capacity utilisation of comparables) and instances where the TPO/AO did not examine documentary material submitted. Following coordinate-bench precedent, it remits issues (capacity, customs duty, forex, inclusion/exclusion of certain comparables, royalty substantiation and SWD comparables) to TPO/AO for fresh adjudication with specified directions (obtain data, apply comparability criteria, follow OECD guidance, afford opportunity of hearing). Ratio vs. Obiter: Ratio - remittal is appropriate where technical/factual determinations require primary fact-finding or non-public data acquisition; such remittals are binding procedural directions. Conclusion: Multiple contested issues are remitted to AO/TPO for fresh, reasoned decisions consistent with Rule 10B/10D, OECD guidance and extant Tribunal precedent, with opportunity to be heard and power to obtain necessary information.