Transfer pricing to benchmark trading and manufacturing separately; inventory provision write-backs to affect ALP, AE-only adjustments

ITAT held that, for AY 2012-13, the TP benchmarking of the assessee's international transactions must separately and independently evaluate its trading and manufacturing segments. The order of the CIT(A) was set aside and the matter remanded to the AO/TPO for fresh benchmarking after due opportunity of hearing. On the provision for slow-moving/obsolete inventory, ITAT directed the AO to verify whether such provisions are written back upon sale; if so, the corresponding deduction is allowable and must be factored into ALP determination. ITAT further directed that any TP adjustment be strictly confined to the assessee's international transactions with its AEs.

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1. ISSUES PRESENTED AND CONSIDERED

1.1 Whether transfer pricing adjustment on export/sale of finished goods to associated enterprises could be made by aggregating trading and manufacturing activities instead of benchmarking them separately.

1.2 Whether the provision for slow moving/obsolete inventory is an allowable deduction and how it should be treated while computing transfer pricing margins.

1.3 Whether transfer pricing adjustment, if any, is to be restricted only to the value of international transactions with associated enterprises and not computed on the entire turnover of the assessee.

1.4 Whether, in view of identical facts and issues, the findings and directions for assessment year 2012-13 apply mutatis mutandis to assessment year 2013-14.

2. ISSUE-WISE DETAILED ANALYSIS

Issue 1 - Aggregation vs. separate benchmarking of trading and manufacturing activities for transfer pricing

Interpretation and reasoning

2.1 The assessee was engaged in two distinct activities: (i) manufacturing, and (ii) trading of hydraulic accessories and spares. The Assessing Officer had treated the entire operations as a single activity and made a transfer pricing adjustment on an aggregated basis to the sale of finished goods to associated enterprises.

2.2 The assessee contended that its trading and manufacturing activities were functionally different and had been separately analysed under the Transactional Net Margin Method (TNMM), with separate margin analyses for domestic and export segments.

2.3 The Tribunal noted that in the assessee's own case for an earlier year, it had already been conclusively held that the assessee was engaged in two separate activities, one manufacturing and one trading, and that the matter had been remitted to the Assessing Officer / TPO with a specific direction to benchmark the two activities separately under TNMM, after examining comparables and determining the arm's length price independently for each.

2.4 Both parties before the Tribunal accepted that the facts and circumstances for the impugned assessment years were identical to those in the earlier year already decided by the Tribunal.

Conclusions

2.5 The assessee is to be treated as engaged in two distinct activities - manufacturing and trading - and these must be benchmarked separately and independently for transfer pricing purposes.

2.6 The orders of the first appellate authority granting blanket relief on an aggregated basis were set aside, and for both assessment years 2012-13 and 2013-14, the matter was restored to the file of the Assessing Officer/TPO with a direction to determine the arm's length price by separately benchmarking the manufacturing and trading activities under TNMM, after affording reasonable opportunity of hearing to the assessee.

Issue 2 - Allowability and treatment of provision for slow moving / obsolete inventory

Interpretation and reasoning

2.7 The assessee had created and claimed deduction for a provision for slow moving inventories / obsolete stock (Rs. 21,79,677 for A.Y. 2012-13), following a consistent policy of periodically writing off inventories and reversing provisions upon subsequent realization.

2.8 The Assessing Officer treated the provision as a mere estimate and disallowed it, noting that in the relevant year no amount was written back and that the basis of provisioning was self-adopted.

2.9 The first appellate authority upheld the disallowance principally on the ground that the said provision had already been considered while computing transfer pricing margins and, since transfer pricing addition had been deleted in favour of the assessee, the provision was already "suffered in the profits" and could not be allowed again.

2.10 Before the Tribunal, it was highlighted that the assessee had been consistently creating such provisions year after year on account of stock getting obsolete, effectively claiming deduction over time, and that this item impacted profitability as well as transfer pricing margins.

2.11 Considering that the core transfer pricing issue was being remitted to the Assessing Officer/TPO for separate benchmarking of manufacturing and trading segments, the Tribunal considered it appropriate that the treatment of the provision for slow moving inventory be re-examined in that integrated context.

Conclusions

2.12 The issue of allowability of the provision for slow moving / obsolete inventory was remitted to the Assessing Officer for fresh examination.

2.13 The Assessing Officer was directed to verify, in particular, whether the assessee had written back such provision at the time of effecting sale of the goods in subsequent periods; if so, deduction could be allowed to that extent and the provision's impact to be factored appropriately in determining the arm's length price while benchmarking the assessee's activities.

2.14 For assessment year 2013-14, the ground concerning slow moving inventory was held to be identical in facts and law to that for assessment year 2012-13, and the same directions of remand and verification were ordered to apply mutatis mutandis.

Issue 3 - Scope of transfer pricing adjustment: restriction to AE transactions vs. entire turnover

Legal framework (as discussed)

2.15 The Tribunal entertained an additional legal ground that any transfer pricing adjustment, if ultimately warranted, should be restricted only to international transactions entered into with associated enterprises and not applied to the assessee's entire turnover.

2.16 Relying on the principles laid down in binding and persuasive judicial precedents, including decisions of the jurisdictional High Court, other High Courts and coordinate benches, as quoted and followed in an earlier Tribunal decision, it was noted that:

- Transfer pricing adjustment has to be confined to international transactions with associated enterprises and cannot be made at the entity level on total turnover.

Interpretation and reasoning

2.17 The additional ground was admitted as purely legal in nature, not requiring fresh fact-finding, consistent with the law permitting admission of such grounds by the Tribunal when all necessary facts are already on record.

2.18 The Tribunal followed the coordinate bench's earlier ruling which, on similar arguments and authorities, had directed that transfer pricing adjustments must be computed only with reference to associated enterprise transactions.

Conclusions

2.19 The Assessing Officer/TPO was directed that any transfer pricing adjustment, arising after fresh benchmarking of the manufacturing and trading activities, must be restricted strictly to the value of the international transactions with associated enterprises and not computed on the assessee's entire turnover.

2.20 The additional legal ground raised by the assessee was allowed.

Issue 4 - Application of findings for A.Y. 2012-13 to A.Y. 2013-14

Interpretation and reasoning

2.21 For assessment year 2013-14, both parties agreed that the facts and issues concerning: (i) transfer pricing adjustment on export of finished goods to associated enterprises, and (ii) disallowance/allowability of provision for slow moving inventory, were identical and similar to those for assessment year 2012-13.

2.22 The Tribunal, following the rule of consistency and in view of the admitted identical nature of the issues, adopted the same approach as in assessment year 2012-13.

Conclusions

2.23 The directions issued for assessment year 2012-13 to re-benchmark trading and manufacturing activities separately and to re-examine the provision for slow moving inventory were ordered to apply mutatis mutandis for assessment year 2013-14.

2.24 Consequently, for assessment year 2013-14 also, the transfer pricing issue and the slow moving inventory issue were remitted to the Assessing Officer/TPO for fresh determination in line with the findings for assessment year 2012-13, with transfer pricing adjustment, if any, to be restricted to associated enterprise transactions only.

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