Transfer pricing analysis excludes COVID idle-capacity costs and foreign exchange loss, while receivable interest is benchmarked to LIBOR.

Transfer pricing analysis for an engineering support assessee turned on functional characterisation, comparability and receivable-interest benchmarking. The re-characterisation of structural detailing and back-end support from ITeS to KPO was rejected because the FAR analysis did not support a high-end knowledge-based profile, and the transfer pricing study was accepted. Operating margin was to be recomputed by excluding COVID-period salary cost, finance cost on long-term borrowings and foreign exchange loss as non-operating or extraordinary items. L&T Technology Services Ltd. and XS CAD India Pvt. Ltd. were excluded as comparables, while additional comparables were remitted for verification. Interest on receivables was upheld on a 60-day credit period, with the rate to be benchmarked at LIBOR plus 200 basis points.

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Issues: (i) whether the services rendered by the assessee were rightly re-characterised from ITeS to KPO and the assessee's transfer pricing study was liable to be rejected; (ii) whether the profit level indicator had to be recomputed by excluding COVID-period salary cost, finance cost and forex loss; (iii) whether L&T Technology Services Ltd. and XS CAD India Pvt. Ltd. were comparable and whether additional comparables could be admitted for verification; and (iv) whether interest on outstanding receivables was chargeable and, if so, at what credit period and rate.

Issue (i): whether the services rendered by the assessee were rightly re-characterised from ITeS to KPO and the assessee's transfer pricing study was liable to be rejected

Analysis: The assessee rendered structural detailing and back-end support services on drawings supplied by the AE, using low-end manpower and software support. On that functional profile, the services were not in the nature of high-end knowledge-based services. The rejection of the assessee's transfer pricing documentation was found to be unsupported by a proper FAR analysis and was based substantially on one filter that was not material to the comparables relied upon by the assessee. The fresh search undertaken by the Transfer Pricing Officer was therefore not sustained.

Conclusion: The re-characterisation from ITeS to KPO was held to be incorrect and the transfer pricing documentation was directed to be accepted.

Issue (ii): whether the profit level indicator had to be recomputed by excluding COVID-period salary cost, finance cost and forex loss

Analysis: Salary paid during the COVID period was treated as an extraordinary and non-recurring cost arising from lockdown-induced idle capacity and was held not to represent ordinary operating expense. Finance cost relating to long-term borrowings for capital assets was held to be outside operating cost. Foreign currency fluctuation loss was also held not to form part of operating revenue for the relevant transfer pricing computation. Rule 10B adjustments were considered applicable to remove material comparability distortions.

Conclusion: The assessee's operating margin was directed to be accepted by excluding COVID-period salary cost, finance cost and forex loss.

Issue (iii): whether L&T Technology Services Ltd. and XS CAD India Pvt. Ltd. were comparable and whether additional comparables could be admitted for verification

Analysis: L&T Technology Services Ltd. was held to fail the turnover filter and to be materially dissimilar in scale and verticals. XS CAD India Pvt. Ltd. was held to be functionally different, involving higher-end engineering design activity and an altered business model arising from an extraordinary event. Additional comparable companies for a later year were admitted for limited verification because the question of functional similarity required examination of the relevant filters and facts.

Conclusion: L&T Technology Services Ltd. and XS CAD India Pvt. Ltd. were directed to be excluded, while the claim for inclusion of the additional comparables was remitted for verification.

Issue (iv): whether interest on outstanding receivables was chargeable and, if so, at what credit period and rate

Analysis: The agreement with the AE was not accepted as determinative of the arm's length credit period in the absence of evidence showing parity with non-AE credit terms. A standard 60-day credit period was upheld. However, where the receivables were denominated in foreign currency, the appropriate benchmark for interest was held to be LIBOR plus appropriate basis points rather than the domestic SBI deposit rate.

Conclusion: Interest on receivables was upheld in principle on a 60-day basis, but the rate was directed to be recomputed using LIBOR plus 200 basis points.

Final Conclusion: The appeal succeeded on the principal transfer pricing issues and on the benchmark rate for receivables, while the credit-period adjustment was sustained, resulting in partial relief to the assessee.

Ratio Decidendi: In transfer pricing, extraordinary COVID-related idle-capacity costs, non-working-capital finance costs and foreign exchange fluctuation loss may be excluded from the operating margin where they do not reflect normal operating conditions, and receivable-interest benchmarking for foreign-currency receivables must be linked to the currency of denomination.

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