ITAT excludes multiple companies from transfer pricing comparables due to functional differences and high export sales

ITAT Delhi directed exclusion of multiple companies from transfer pricing comparables for an auto components manufacturer. Brakes India Pvt. Ltd., Clutch Auto Ltd., and ANG Industries Ltd. were excluded due to functional dissimilarity, high export sales, and different geographical markets respectively. Faiveley Transport and Rane Brake Lining Ltd. were excluded for high AMP expense ratios exceeding 2% filter. However, XLO India Ltd. was retained despite negative net worth as profits improved over three years. Foreign exchange gains must be included in operating income calculations. TPO directed to reconsider depreciation adjustments for profit level indicators following precedent decisions.

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Issues Involved:

1. Adjustment in Arm's Length Price (ALP) of international transactions.
2. Selection of comparable companies.
3. Consideration of foreign exchange gain as operating income.
4. Adjustment on account of high depreciation.
5. Use of cash profit/operating income as a profit level indicator.

Detailed Analysis:

1. Adjustment in Arm's Length Price (ALP) of International Transactions:

The Assessee and Revenue both contested the adjustments made to the ALP of international transactions for the assessment years 2011-12 and 2012-13. The Assessee argued that the adjustments were erroneous due to incorrect selection of comparables and exclusion of certain income elements. The Revenue challenged the deletion of disallowances made by the CIT(A).

For AY 2011-12, the TPO had computed an adjustment of Rs. 1,66,03,544 based on a set of comparables with an average PLI of 7.84%. The Assessee's PLI was computed at 1.33%. The Tribunal partly allowed the Assessee's appeal for statistical purposes, directing the TPO to reconsider the adjustments in light of the Tribunal's findings.

2. Selection of Comparable Companies:

The selection of comparables was a significant issue, with the Assessee contesting the inclusion of companies like Elofic Industries Ltd., WABCO TVS (India) Ltd., and Brakes India Pvt. Ltd. The Tribunal, following its earlier decisions, excluded these companies due to factors like high export turnover and functional dissimilarity.

For AY 2012-13, the Tribunal directed the exclusion of Brakes India Pvt. Ltd. and Clutch Auto Ltd. from the list of comparables, citing similar reasons. The Tribunal emphasized the need for comparables to have similar geographical markets and functional profiles.

3. Consideration of Foreign Exchange Gain as Operating Income:

The Assessee argued that foreign exchange gains should be considered as operating income, which was initially rejected by the CIT(A) based on Safe Harbour Rules. However, the Tribunal, referencing its decision for AY 2010-11, directed that foreign exchange gains be treated as part of operating income for computing operating margins.

4. Adjustment on Account of High Depreciation:

The Assessee sought adjustments for high depreciation costs, arguing that it affected profitability comparisons. The CIT(A) had rejected this on the basis that depreciation adjustments are not typically allowed. The Tribunal, however, remanded the issue back to the TPO for reconsideration, citing similar cases where cash profits were used to account for excessive depreciation.

5. Use of Cash Profit/Operating Income as Profit Level Indicator:

The Assessee contended that cash profit should be used as a profit level indicator due to high depreciation. The Tribunal, following its previous decisions, remanded the issue to the TPO for fresh consideration, allowing the Assessee to demonstrate the impact of depreciation on profitability.

Conclusion:

The Tribunal's judgment involved a detailed examination of the selection of comparables, treatment of foreign exchange gains, and adjustments for depreciation. The appeals were partly allowed for statistical purposes, with directions for the TPO to reconsider certain issues in light of the Tribunal's findings and previous decisions. The judgment underscores the importance of accurate comparability analysis and the treatment of income elements in transfer pricing assessments.

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