Transfer pricing matter remanded for fresh determination using TNNM method with 3% tolerance range under section 35(2AB)

ITAT Hyderabad remanded transfer pricing matter to TPO/AO for fresh determination using TNNM method with external and international comparables, directing no adjustment if assessee's operating margin falls within 3% tolerance range of arm's length price. Tribunal allowed weighted deduction under section 35(2AB) following consistency principle from previous year's order. Additional depreciation claim under section 32(iia) was allowed, directing AO to implement DRP's directions which were ignored in final assessment order, criticizing AO's indiscipline in not following DRP's binding directions.

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1. ISSUES PRESENTED and CONSIDERED

The core legal questions considered by the Tribunal in this appeal are as follows:

Transfer Pricing (TP) Issues:

• Whether the adjustment of Rs. 35,15,85,591 related to transfer of raw materials from non-SEZ (API) units to SEZ units and allocation of foreign exchange loss to SEZ units was justified.
• Whether the methodology adopted by the assessee for benchmarking specified domestic transactions, particularly the use of the range concept (35th to 65th percentile) in the Cost Plus Method (CPM), was correctly rejected by the TPO and DRP.
• Whether the TPO erred in making an inter-familial comparison of margins and cherry-picking certain product families instead of considering the entire basket of products for determining the Arms' Length Price (ALP).
• Whether the TPO and DRP misinterpreted OECD Transfer Pricing Guidelines by adopting a restricted approach and ignoring the overall profitability of the product families or segments.
• Whether the internal and external Transactional Net Margin Method (TNMM) analyses submitted by the assessee, showing operating profit margins within arm's length range, were improperly disregarded.
• Whether the forex loss allocation methodology adopted by the TPO/DRP was flawed as it did not consider the nature of forex loss pertaining to both imports and exports.

Non-Transfer Pricing Issues:

• Whether the Assessing Officer and DRP erred in disallowing weighted deduction under section 35(2AB) of the Income Tax Act, 1961, in respect of expenditure incurred on clinical trials, bio-analytical, and bio-equivalence studies, especially when the DSIR approval and judicial precedents supported the claim.
• Whether the disallowance of weighted deduction related to Research & Development (other than clinical trials) due to absence of Form 3CL at the time of assessment was justified.
• Whether the Assessing Officer erred in not allowing additional depreciation under section 32(iia) despite directions from the DRP.

2. ISSUE-WISE DETAILED ANALYSIS

Transfer Pricing Adjustments on Specified Domestic Transactions (Raw Material Transfer from Non-SEZ to SEZ Units)

Legal Framework and Precedents: The determination of ALP for specified domestic transactions is governed under sections 92CA and 92C of the Income Tax Act, 1961, with Rule 10CA prescribing the application of various methods including CPM and TNMM. The OECD Transfer Pricing Guidelines provide interpretative guidance on arm's length principle and benchmarking.

Court's Interpretation and Reasoning: The Tribunal noted that the assessee adopted CPM as the most appropriate method, benchmarking the transfer pricing by comparing the operating profit margins of non-SEZ units' sales to third parties with those of sales to SEZ units, applying the range concept (35th to 65th percentile) as mandated by Rule 10CA(4) when six or more comparable items exist. The TPO rejected this methodology on the ground that the 11 product families were distinct and taking percentiles excluded 70% of products, resulting in a distorted ALP.

The TPO instead cherry-picked only 6 product families for benchmarking, leading to an upward adjustment of Rs. 90.05 crores, later revised. The DRP confirmed this adjustment and rejected the supplementary TNMM analysis submitted by the assessee.

The Tribunal found fault with both approaches: the assessee's exclusion of 70% of products distorted the outcome, and the TPO's selective picking of products was equally improper. The Tribunal emphasized that when the assessee transfers a basket of 11 families of formulations from one unit to another, the entire basket must be considered for ALP determination, not selective families.

Further, the Tribunal observed that in the subsequent assessment year (AY 2020-21), the TPO himself accepted TNMM as the most appropriate method and conducted an independent search for comparables, applying filters to arrive at a set of seven comparable companies. However, the TPO ultimately used only two of these in the final ALP determination without adequately explaining the rejection of the others.

The assessee's supplementary TP analysis for AY 2019-20, based on external TNMM benchmarking using 14 comparable companies, showed the assessee's operating profit margin of 25.21% was within the arm's length range (35th percentile 15.73%, median 20.61%, 65th percentile 29.65%). The Tribunal held that since the TPO accepted TNMM as the appropriate method for the subsequent year, the supplementary TNMM analysis for the year under consideration should be considered.

Application of Law to Facts: The Tribunal remanded the matter to the TPO/Assessing Officer to determine ALP adopting TNMM as the most appropriate method, utilizing external comparables and international comparables, and to consider the assessee's operating margin within a tolerance range of 3%. The assessee must be given an opportunity of hearing before passing a fresh order.

Treatment of Competing Arguments: The Tribunal rejected the TPO's cherry-picking approach and the assessee's exclusionary percentile approach as both leading to distorted results. It relied on the principle of considering the entire basket of products and the consistency in methodology adopted in the subsequent year.

Conclusion: The TP adjustment on specified domestic transactions was set aside and remanded for fresh determination based on TNMM and external comparables, with due process.

Allocation of Foreign Exchange Loss

The assessee challenged the allocation of forex loss to SEZ units in proportion to export turnover, arguing that forex loss relates to both imports and exports and should not be allocated solely on export turnover basis. The Tribunal did not explicitly elaborate on this issue in the judgment excerpt but implied that the TPO/DRP's allocation methodology was flawed for not appreciating the mixed nature of forex loss. This issue would presumably be reconsidered on remand.

Disallowance of Weighted Deduction under Section 35(2AB)

Legal Framework and Precedents: Section 35(2AB) provides for weighted deduction (150%) on expenditure incurred on scientific research related to the business. The Explanation to the section clarifies that expenditure on clinical trials and obtaining regulatory approvals, even if conducted outside the in-house R&D facility, qualify for weighted deduction if approved by prescribed authorities such as DSIR. The Tribunal relied on judicial precedents including the decision of the Gujarat High Court in CIT vs. Cadila Healthcare Ltd, which held that clinical trials need not be confined to in-house facilities and expenses incurred outside approved R&D facilities are eligible for weighted deduction.

Court's Interpretation and Reasoning: The Assessing Officer restricted weighted deduction to in-house R&D expenditure, disallowing clinical trial expenses and other R&D expenses due to absence of Form 3CL at the time of assessment. The Tribunal noted that the DSIR had approved the R&D facility and provided detailed expenditure reports including clinical trial expenses conducted outside the approved facility. Following the principle of consistency and binding precedents, the Tribunal held that the entire R&D expenditure, including clinical trials and bio-analytical studies, qualified for weighted deduction under section 35(2AB).

Application of Law to Facts: The Tribunal applied the legal principle established in Cadila Healthcare and subsequent orders of coordinate Benches in the assessee's own case to allow the weighted deduction for the entire R&D expenditure as approved by DSIR, including clinical trials outside the in-house facility.

Treatment of Competing Arguments: The Tribunal rejected the Assessing Officer's restrictive interpretation and non-consideration of Form 3CL received after the assessment order, emphasizing the legal entitlement of the assessee to weighted deduction on the basis of DSIR approval and judicial precedents.

Conclusion: The disallowance of weighted deduction under section 35(2AB) was set aside and the claim allowed in full as per DSIR approval.

Disallowance of Additional Depreciation under Section 32(iia)

Legal Framework: Section 32(iia) allows additional depreciation on new machinery or plant used in manufacture or production. The proviso requires that the asset be used for at least 180 days in the previous year.

Court's Interpretation and Reasoning: The Assessing Officer disallowed additional depreciation on the ground that the machinery was used for less than 180 days. However, the DRP considered the submissions and directed the Assessing Officer to allow the claim, noting that the machinery was used in quality control departments across multiple manufacturing facilities.

The Tribunal observed that the Assessing Officer failed to comply with the DRP's directions in the final assessment order, which was improper and reflected indiscipline.

Application of Law to Facts: The Tribunal directed the Assessing Officer to give effect to the DRP's directions and allow the additional depreciation claimed by the assessee.

Treatment of Competing Arguments: The Tribunal rejected the Assessing Officer's non-compliance with DRP's order and upheld the DRP's reasoning.

Conclusion: The additional depreciation disallowance was set aside and the claim allowed as per DRP's directions.

3. SIGNIFICANT HOLDINGS

The Tribunal made several important determinations and established core principles as follows:

On Transfer Pricing:

"When the assessee is selling its formulation under 11 families from one unit to another unit of the assessee, then the entire lot of formulation will be considered as a basket of products and the TPO is not justified in picking only some of the products which are having low price and excluding the products which are having higher prices in comparison to the unrelated transactions of the assessee."

"Neither methodology applied by the assessee which excludes 70% of the products while determining the ALP and benchmarking its specified domestic transactions in the TP study is acceptable as resulting a distorted outcome, nor the action of the TPO while cherry picking some of the products out of the total basket of 11 product formulations showing as 11 families of the formulation is a right approach."

"Since the TPO himself has accepted the TNMM as most appropriate method for determining the ALP in the subsequent year, then the supplementary TP analysis submitted by the assessee ought to have been considered for the purpose of determining the ALP for the year under consideration."

The Tribunal remanded the transfer pricing issue for fresh determination adopting TNMM with external comparables and directed adherence to the tolerance range of 3%.

On Weighted Deduction under Section 35(2AB):

"The clinical trials are not always possible to be conducted in the closed laboratory or in house like facilities and are required to be conducted outside the approved facility and if we go by the restricted interpretation resorted to by the Revenue, such an interpretation renders the explanation meaningless."

"Following the earlier order of this Tribunal and allow the claim of the assessee u/s 35(2AB) of the I.T. Act, 1961 for the entire expenditure as referred in the report of the DSIR."

The Tribunal held that weighted deduction is allowable on clinical trial and related expenses outside the in-house R&D facility when approved by DSIR, consistent with judicial precedents.

On Additional Depreciation under Section 32(iia):

"The Panel is convinced with argument of the assessee. The Assessing Officer is directed to allow the claim of additional depreciation 32(iia)."

"The Assessing Officer has not given effect to the directions of the DRP which is not only uncalled for but also reflects the indiscipline on the part of the Assessing Officer. Accordingly, we direct the Assessing Officer to give effect to the directions of the DRP and allow the claim of the additional depreciation as directed by the DRP."

The Tribunal upheld the DRP's direction and ordered the Assessing Officer to allow additional depreciation.

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