Reduced sales to related entities cannot justify rejecting idle capacity adjustments during recession period

ITAT Chennai ruled in favor of the assessee on multiple transfer pricing and tax issues. The tribunal held that reduced sales to associated enterprises cannot justify rejecting idle capacity adjustments, particularly during global recession when the assessee's capacity utilization was only 23% compared to industry average of 70%. Only actual forex losses should be treated as operating expenses, not notional losses. The tribunal excluded one comparable company but included another in software development segment analysis. Higher depreciation rate of 60% was allowed on software applications. Reimbursement of seconded employee costs was held not liable for section 40(a)(i) disallowance as TDS was already deducted under section 192.

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1. ISSUES PRESENTED and CONSIDERED

The core legal questions considered by the Tribunal in this consolidated appeal include:

- Whether the Transfer Pricing Officer's (TPO) order dated November 1, 2017, was barred by limitation under Section 92CA(3A) read with Section 153 of the Income Tax Act, 1961.

- Whether the Commissioner of Income Tax (Appeals) erred in failing to record an opinion under Section 92C(3) and in disregarding the Transfer Pricing (TP) study maintained by the assessee under Section 92D read with Rule 10D.

- Whether the rejection of economic adjustments claimed by the assessee, specifically idle capacity adjustment, non-cenvatable customs duty adjustment, and foreign exchange (forex) gain/loss adjustment, was justified under the relevant provisions and judicial precedents.

- Whether the entity-level adjustment methodology adopted by the TPO was appropriate.

- Whether the comparable companies selected or rejected by the TPO and CIT(A) for the Software Development Services segment were functionally and financially comparable, and whether the inclusion or exclusion of such comparables was justified.

- Whether risk profile differences between the assessee and comparables warranted economic adjustments.

- Whether the Revenue erred in deleting additions made by the Assessing Officer (AO) on account of notional forex loss, provision for obsolescence of stock, depreciation on software licenses, and disallowance under Section 40(a)(i) relating to reimbursement of seconded employees' costs.

- Whether the foreign exchange loss on restatement of External Commercial Borrowings (ECBs) is allowable as revenue expenditure or should be disallowed as capital in nature.

- Whether the provision for obsolescence stock is allowable as a deduction under the Income Tax Act.

- Whether the depreciation rate applicable to software licenses should be 60% (as for computers) or 25% (as for intangible assets).

- Whether reimbursements made for seconded employees' salaries to Associated Enterprises (AEs) attract tax deduction at source (TDS) under Sections 192 or 195, and whether such reimbursements constitute "fees for technical services."

2. ISSUE-WISE DETAILED ANALYSIS

A. Limitation on Transfer Pricing Order

The assessee contended that the TPO's order was barred by limitation under Section 92CA(3A) read with Section 153 of the Act. However, this ground was not pressed before the Tribunal and was accordingly dismissed.

B. Failure to Record Opinion under Section 92C(3) and Disregard of TP Study

The assessee's general grounds alleging failure by the CIT(A) and AO to record an opinion under Section 92C(3) and erroneous disregard of the TP study were also not pressed and dismissed as generic and unsubstantiated.

C. Manufacturing Segment: Economic Adjustments

Idle Capacity Adjustment: The assessee claimed that due to global recession and business peculiarities, the manufacturing units operated at only 23% of installed capacity, significantly lower than industry averages and comparable companies. The assessee sought an economic adjustment under Rule 10B(3)(ii) to eliminate material differences affecting profits, proposing three approaches: (i) based on own preceding years' average capacity (43%), (ii) based on capacity data of comparable companies (to be obtained under Section 133(6)), and (iii) based on industry average capacity as reported by RBI and FICCI.

The TPO and CIT(A) rejected the idle capacity adjustment primarily on the ground that the decline in capacity was due to reduced sales to AEs, which the authorities considered insufficient to warrant adjustment. The Tribunal disagreed, holding that the assessee, as a full-fledged entrepreneur bearing all risks without any committed AE sales, cannot be denied adjustment merely because AE sales declined. The Tribunal relied on the Bangalore ITAT decision in Denso Kirloskar, which held that capacity under-utilization adjustment must be considered where the assessee's capacity utilization is materially lower than comparables due to market conditions.

The Tribunal further observed that idle capacity can arise from various reasons beyond start-up phases, including recession and sectoral downturns, and that the facts showed a significant capacity gap (23% vs. industry average ~70%). The Tribunal remitted the quantification of the adjustment to the TPO for fresh consideration based on the approaches proposed by the assessee.

Non-Cenvatable Customs Duty Adjustment: The assessee claimed adjustment for non-cenvatable customs duty in the Machine & Parts segment, arguing that comparable companies did not bear this cost due to indigenized operations. The TPO rejected this claim on the basis that the assessee could not indigenize manufacturing operations. The Tribunal directed the TPO to reconsider this issue in light of the jurisdictional Tribunal's precedent in Doowon Automotive Systems India Pvt Ltd, after the assessee furnishes necessary details.

Foreign Exchange Gain/Loss Adjustment: The TPO treated forex loss as an operating expense in computing margins, reasoning that the assessee bore forex risk. The assessee contended that only realized forex loss should be treated as operating expense, while unrealized (notional) forex loss on restatement should be excluded, relying on CBDT Safe Harbour Rules and judicial precedents.

The Tribunal held that forex translation gains/losses are generally operating in nature but accepted the assessee's contention that only actual realized forex loss should be included, while notional unrealized loss should be excluded. Accordingly, this ground was partly allowed.

Entity-Level Adjustment: The assessee's contention on restricting transfer pricing adjustment to the proportion of international transactions was not adjudicated as it became academic given remand of primary issues.

D. Software Development Services Segment: Comparable Companies

The assessee adopted TNMM with 7 comparable companies yielding a margin of 14.66%, while the TPO rejected 5 comparables and added 6 others, resulting in 8 comparables with an average margin of 29.40%. The CIT(A) excluded 4 of the TPO's comparables and rejected the assessee's comparables.

The Tribunal considered the following:

- Thirdware Solutions Ltd: The assessee argued this was functionally dissimilar and had been excluded in earlier years by the Tribunal and Mumbai Tribunal precedents. The Tribunal directed exclusion of this comparable.

- Spry Resources India Pvt Ltd: The TPO rejected this comparable on the ground of disproportionate sales to receivables ratio, but the Tribunal found this reasoning unsound and accepted the assessee's contention that the company was functionally comparable and passed all filters. The Tribunal ordered inclusion of Spry Resources.

The Tribunal observed that if Thirdware Solutions Ltd is excluded and Spry Resources included, the margins would fall within the tolerance range, rendering other inclusion/exclusion issues and risk adjustment grounds academic.

E. Revenue's Grounds of Appeal

Disallowance of Notional Forex Loss: The AO disallowed notional forex loss of Rs. 75.7 crores on restatement of ECBs, reasoning that such loss is capital in nature and affects only settlement, not day-to-day profits. The CIT(A) allowed the loss relying on jurisdictional precedents. The Tribunal remitted the issue to AO for fresh adjudication to verify facts such as whether the ECB was used for acquiring assets in India and whether assets were put to use, directing application of the ratio in Hyundai Motor India Ltd v. DCIT.

Provision for Obsolescence: The AO disallowed provision for obsolescence stock on the ground that provisions are not allowable deductions under the Act. The CIT(A) allowed it based on consistent accounting practice. The Tribunal, following its own precedent and a Karnataka High Court decision, held that mere provision for obsolete stock is not allowable and that loss can only be claimed on actual sale. However, since the provision was disallowed in the preceding year as well, the Tribunal directed AO to rework opening and closing stock accordingly.

Depreciation on Software: The AO restricted depreciation on software to 25% treating it as intangible asset license. The CIT(A) allowed 60% depreciation following the jurisdictional High Court decision that software application licenses are eligible for 60% depreciation. The Tribunal upheld the CIT(A)'s order in favor of the assessee.

Disallowance under Section 40(a)(i) for Reimbursement of Seconded Employees' Cost: The AO disallowed reimbursement payments to AEs on the ground that they constitute "fees for technical services" attracting TDS under Section 195. The CIT(A) allowed the claim relying on TDS deduction under Section 192 on salary payments and prior Tribunal decisions. The Tribunal upheld the CIT(A)'s order, holding that the payments were mere reimbursements of salary costs already subjected to TDS under Section 192 and did not constitute separate fees.

3. SIGNIFICANT HOLDINGS

"Merely because the sales to AE is reduced cannot be a factor to reject idle capacity adjustment."

The Tribunal established that an assessee bearing normal business risks without committed AE sales cannot be denied adjustment for underutilized capacity solely because sales to AE declined. Idle capacity adjustments can arise from various causes including recession and are not restricted to start-up phases.

"Only actual forex loss should be treated as operating expense and the notional Forex loss should not be treated as operating expense."

The Tribunal clarified that realized foreign exchange losses are operating expenses for transfer pricing purposes, but unrealized notional losses on restatement should be excluded.

"Provision for old stock could not be allowed to the assessee by way of deduction in the computation of income. The profit or loss arising therefrom would accrue only at the time of sale thereof."

The Tribunal reaffirmed that provisions for obsolescence are not allowable deductions under the Income Tax Act; losses are recognized only on actual sale.

"Where software license acquired by assessee was in nature of software application, the assessee would be eligible to claim depreciation at 60%."

The Tribunal followed the jurisdictional High Court ruling allowing higher depreciation on software application licenses as against the rate applicable to intangible assets.

"Payments for seconded employees to AEs are mere reimbursements and do not include any element of income, having already suffered TDS under Section 192."

The Tribunal held that such reimbursements do not constitute fees for technical services attracting separate TDS under Section 195.

On the issue of selection of comparables for software development segment, the Tribunal excluded Thirdware Solutions Ltd based on functional dissimilarity upheld in prior rulings, and included Spry Resources India Pvt Ltd, finding the rejection grounds unsound. This adjustment brought the margins within arm's length range, rendering other comparable inclusion/exclusion and risk adjustment issues academic.

The Tribunal remitted the quantification of idle capacity adjustment and customs duty adjustment to the TPO for fresh adjudication after considering the assessee's detailed submissions and judicial precedents, ensuring a fact-based determination.

The Tribunal also remitted the issue of notional forex loss on ECB restatement to the AO for fresh examination of facts regarding the use and put-to-use status of assets acquired from the ECB, directing application of relevant precedents.

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