Notional costs for free services from associated enterprises excluded from operating costs for profit indicators

ITAT Bangalore ruled on multiple transfer pricing and tax issues. The tribunal held that notional costs for free services from associated enterprises should not be included in operating costs for calculating profit level indicators, directing TPO to exclude such costs. The comparable selection issue was remanded to TPO for fresh adjudication. Regarding outstanding receivables from associated enterprises, ITAT confirmed these constitute international transactions requiring separate benchmarking at LIBOR+200 basis points with 30-day credit period. Interest expenses on compulsorily convertible debentures were allowed as deduction. However, delayed provident fund contributions were disallowed following SC precedent in Checkmate Services. The tribunal directed verification and allowance of TDS credits per statutory provisions.

---

---

ISSUES PRESENTED AND CONSIDERED

1. Whether notional costs incurred by an associated enterprise (AE) - including share-based compensation (ESOP), and notional cost/depreciation of tangible/intangible assets supplied free of cost by the AE - can be included in the tested party's operating expenses for computing the Profit Level Indicator (PLI) under TNMM.

2. Whether the comparable set adopted by the Transfer Pricing Officer (TPO)/Dispute Resolution Panel (DRP) is appropriate, specifically whether several identified companies are functionally comparable to the assessee for benchmarking ITES transactions under TNMM.

3. Whether overdue/delayed receivables from AEs constitute an international transaction requiring separate benchmarking and, if so, the appropriate interest rate to compute notional interest on such receivables.

4. Whether interest expense claimed on Compulsorily Convertible Debentures (CCDs) issued to AE is allowable as deduction (i.e., whether CCDs should be treated as debt for the period prior to conversion).

5. Whether delayed contribution under the Provident Fund Act (employer's delayed deposit of employee contributions) is deductible.

6. Whether the assessee is entitled to the full credit for Tax Deducted at Source (TDS) claimed.

7. Whether reliefs/charges consequential to primary adjustments (interest under section 234B and penalty under section 270A) should be determined at this stage.

ISSUE-WISE DETAILED ANALYSIS

Issue 1 - Inclusion of notional costs (ESOP, notional depreciation/use of AE assets) in operating cost for TNMM

Legal framework: TNMM under Rule 10B(1)(e) requires computation of net profit margin "in relation to costs incurred ... by the enterprise" (i.e., the tested party). Rule 10TA (2017 amendment) expanded definition of operating expense to include share-based compensation but is applicable only where safe harbour rules are opted for and is prospective.

Precedent treatment: The Tribunal and High Court authorities (as referenced in the record) have held that imputing or including costs incurred by third parties/AEs or applying ad hoc percentage additions to operating cost is impermissible under TNMM; tribunal orders have also excluded ESOP valuations included by TPO in certain contexts.

Interpretation and reasoning: The Court emphasises textual mandate that TNMM computes the tested party's margin with reference to costs incurred by that party, not costs borne by AEs or third parties. The TPO's approach of adding a blanket 10% ad hoc of operating expenditure (and fixed USD amount) to account for ESOP/asset use improperly imputes notional costs not borne by the assessee. The Rule 10TA amendment cannot be invoked as it is prospectively applicable only if safe harbour is opted; the assessee did not opt for safe harbour for the year in question. Consistency is relevant: absent change in facts, prior years when no such adjustment was made weigh against making the adjustment in the year under consideration.

Ratio vs. Obiter: Ratio - TNMM requires reference to costs incurred by the tested party; notional costs incurred by AE cannot be included in tested party's operating cost for ALP determination under TNMM. Obiter - observations on Rule 10TA applicability and consistency principles as supporting reasoning.

Conclusion: Notional costs (ESOP, notional depreciation/use of AE assets) are not includible in the assessee's operating cost for computing PLI in the facts of the case; the TPO/DRP direction to include them is set aside and the ground is allowed.

Issue 2 - Appropriateness of comparables selected by TPO/DRP for ITES segment

Legal framework: Comparability assessment under Rule 10B(2)(a) requires consideration of service/product characteristics and functional profile; comparables must have a relatively equal degree of comparability considering functions, assets and risks.

Precedent treatment: Multiple Tribunal decisions (coordinate benches) have excluded specific companies performing KPO/BPO/other distinct ITES functions where functional profiles diverge, and have remitted comparability questions for fresh examination when facts differ by assessment year.

Interpretation and reasoning: The Court finds substantive disputes on functional comparability between the assessee and several entities added by the TPO. The AR submitted detailed functional distinctions and relied on prior Tribunal findings where many of the same entities were excluded. Given divergence in fact patterns and year-to-year data issues (use of non-current year data, segmental disclosure, export filters, employee cost filters), the Court considers it appropriate to remit the comparability exercise to the TPO for fresh adjudication applying correct filters and functional analysis in light of relevant precedents and the statutory comparability criteria.

Ratio vs. Obiter: Ratio - where functional dissimilarity or data/filtration defects exist, comparables selection must be revisited; remand is appropriate. Obiter - referencing specific previously excluded entities as guidance but not conclusively deciding comparability for this year.

Conclusion: The matter of comparables is set aside to the file of the TPO for fresh adjudication applying proper filters and functional analysis; the assessee's ground is partly allowed for statistical purposes.

Issue 3 - Treatment of overdue receivables from AE as international transaction and appropriate notional interest rate

Legal framework: Post-amendment jurisprudence treats interest on outstanding receivables from AEs as an international transaction requiring separate benchmarking; rate selection should reflect the currency and market where funds are obtained/consumed.

Precedent treatment: High Court/Tribunal authority supports treating extended credit beyond normal trade credit as effectively granting a loan to AE and benchmarking notional interest using rates prevailing in the currency/location of the borrowing (e.g., LIBOR + spread) rather than domestic PLR.

Interpretation and reasoning: The Court accepts that receivables from AEs constitute an international transaction and require separate arm's length benchmarking. Applying domestic Prime Lending Rate (PLR) is inappropriate where the receivable/loan is in foreign currency; rather, the appropriate yardstick is foreign borrowing rate (LIBOR or its equivalent) plus an appropriate spread. The Court directs recomputation of notional interest using LIBOR + 200 basis points and applying a credit period of thirty days or as per agreement/invoice.

Ratio vs. Obiter: Ratio - overdue receivables from AE are international transactions needing separate benchmarking; PLR is not appropriate for foreign currency receivables; LIBOR-based benchmark with spread is appropriate on facts. Obiter - suggested spread and credit period as pragmatic directions for recomputation.

Conclusion: Direction to treat receivables as international transaction and to recompute notional interest at LIBOR + 200 bps (or similar foreign currency benchmark) with appropriate credit period; appeal allowed for statistical purposes on this ground.

Issue 4 - Allowability of interest on CCDs

Legal framework: Interest on borrowings is deductible under relevant provisions so long as instruments are in nature of debt during the period interest is paid; regulatory requirements mandating future conversion do not alter character of CCDs as debt prior to conversion.

Precedent treatment: Tribunal precedent in the assessee's own case and other pronouncements establishes that CCDs retain the character of debt until conversion and interest paid prior to conversion is allowable; RBI policy or eventual conversion obligations do not negate debt character for the interim period.

Interpretation and reasoning: On identical facts and absent any adverse higher-court ruling, the Court follows coordinate Tribunal precedent in the assessee's own case and allows the deduction of interest on CCDs for the period before conversion. Thin capitalisation rules were not invoked for the relevant year.

Ratio vs. Obiter: Ratio - interest on CCDs is deductible while they retain debt character prior to conversion. Obiter - none material.

Conclusion: Deduction of interest on CCDs is allowable; TPO/DRP disallowance is reversed and ground allowed.

Issue 5 - Deductibility of delayed employer PF contributions

Legal framework and precedent: Supreme Court authority holds that employer's failure to deposit employee contributions by statutory due dates precludes deduction under section 43B; deposit after due date but before filing return does not cure delayed employer-held trust liability.

Interpretation and reasoning: The Court applies binding Supreme Court reasoning that employer's delayed deposit of employee contributions is not deductible; the non-obstante clause does not override the statutory timing requirement.

Ratio vs. Obiter: Ratio - delayed employer PF contributions are disallowable; follows highest-court precedent.

Conclusion: Disallowance sustained; ground dismissed.

Issue 6 - Credit for TDS

Legal framework: Credit for TDS is allowable as per records subject to verification by assessing officer.

Interpretation and reasoning: The assessee asserted entitlement to a higher TDS credit than allowed; Department offered no contrary material. The Court directs AO to verify and allow the correct TDS credit under law.

Ratio vs. Obiter: Ratio - directing verification and allowance of legitimately claimed TDS credit.

Conclusion: Ground allowed for statistical purposes and AO directed to verify and grant appropriate TDS credit.

Issue 7 - Interest under section 234B and penalty under section 270A

Legal framework and reasoning: These are consequential issues dependent on final tax determination and therefore premature at present.

Conclusion: Grounds relating to interest/penalty are dismissed as infructuous at this stage.

---