2025 (10) TMI 989 - AT - Income Tax

Tax authority remits selection of foreign associate as tested party; directs financial data, reliability tests and ALP determination (Rule 10CB)

ITAT remitted the issue of selecting the foreign AE as the tested party to the file of the AO/TPO, directing the assessee to furnish requisite financial ... TP Adjustment - Rejection of AE as tested party - TPO has wrongly rejected the selection of foreign AE as the tested party on the reasoning that sufficient financial data of the AE were not made available - profit derived by the AE from trading segment of finished goods of the appellant assessee - HELD THAT:- We deem it fit to remit the issue of AE as a tested party emerging from grounds numbered e and 4, back to the file of the AO/TPO with a direction to the assessee to substantiate the arm's-length price of the transaction of trading segment of finished goods of the appellant assessee with requisite financial data about the foreign AE as a tested party. TPO may examine that the tested party selected by the assessee gives a reliable method and computation of ALP or not. Thereafter, after giving assessee an opportunity of being heard, determine the arm's-length price of the international transaction of trading segment of finished goods of the appellant assessee. For trading of raw material and API, similar exercise of determining the ALP should be done separately taking AE as tested party. In case the TPO decides otherwise and the appellant assessee does not find favour on this issue from the Ld. TPO; exercise of comparables as done initially subject to finding hereinafter on this issue only in subsequent para will survives. Impairment of tangible assets & loss on sale/disposal of property, plant & equipment - R & D expenses have been capitalized as intangible assets - R & D activities may always not be successful. Even then, such expenses are bound to be incurred and have to be recovered by loading the same to the cost of products manufactured by the assessee. Counsel has not brought any material on the record to establish that the R & D expenses capitalized as intangible asset has been amortized regularly during the expected life of this intangible asset generated from R & D expenses. Hence, charging the same in the relevant year. The case laws relied upon by the Ld. Counsel are held factually different as these case laws are in respect of loss arising from revaluation and accounting treatment of machineries and factory assets. Here, in the present case it is R & D expenses for product development. An operating expense is an expense that a business incurs through its normal business operations. Operating expenses include rent, equipment, inventory costs, marketing, payroll, insurance, and funds allocated for research and development. The non-operating expense is an expense incurred by a business that is unrelated to the business's core operations. A capital expense is a different type of expense that relates to acquiring, maintaining, or upgrading an asset. There is no infirmity in finding of the TPO and the Ld. DRP that the R & D expenses debited as impairment of intangible assets is nothing but operating expenses as the same is directly related to the survival, growth and sustenance of the business. This ground, therefore, fails. Inclusion of loss derived from sale/disposal of property, plant & equipment in operating expenses for determining the ALP - We, in view of the above discussion/ observation/finding on R & D Expenses issue, find merit in the arguments of the Ld. Counsel. We therefore, are of the considered view that the inclusion of loss derived from sale/disposal of property, plant & equipment in operating expenses by the Authorities below is not justified. Hence, we direct the AO/TPO to exclude the loss derived from sale/disposal of property, plant & equipment in operating expenses. Inclusion of Flamingo Lifesciences Ltd. and Everest Organics Ltd. as comparables - TPO has applied export filter of => 25% of the operating turnover. We are of the considered view that the operating turnover should be from manufacturing and or trading only. Not all revenue taken in turnover in the books of account will form the operating turnover. Excluding non-operating revenue from the turnover has to be considered for comparison. We have given thoughtful consideration to the facts of the case and are of the considered view that there is no infirmity in excluding Everest Organics Ltd. from the final set of comparables by the Ld. TPO and the Ld. DRP on the reasoning that this comparable does not pass the export filter. Interest on overdue receivables - TPO allowed credit period of 30 days and worked out interest on overdue receivables from AEs @ LIBOR + 400 bps - In the present case, since the assessee had not factored the impact of receivables on its profitability; therefore, further adjustment for outstanding receivables is held warranted. Thus, the reliance placed on the decision in the case of Kusum Health Care Pvt. Ltd. [2017 (4) TMI 1254 - DELHI HIGH COURT] is of no relevance in view of the facts and findings considered in totality. We do not find any merit in the argument of the Ld. Counsel that the interest should not be worked out overdue receivables from AEs as it has not charged any interest on overdue receivables from third parties as the facts of third parties are totally different. As in the case of Corteva Agriscience Services India Pvt. Ltd. [2023 (11) TMI 190 - ITAT HYDERABAD] accepted the stand of the Revenue in holding overdue receivables from associated enterprises ('AEs') as an international transaction and computed notional interest at the rate of 6 percent on the amount of such outstanding receivable invoices. In general, the ruling has relied upon the decision of Higher Courts, wherein it has been held that the delay in receipt of receivables beyond a reasonable credit period partakes the character of an advance and therefore results in an international transaction in view of explanation to section 92B(2) of the Act, which can be then subjected to computing notional interest. TPO is justified in holding overdue receivables from AE as international transactions and it has to be benchmarked separately for computing notional interest thereon. Accordingly, we order so. In the present case, the rate LIBOR + 400 applied by the AO is also under challenge. We have considered the facts and submission of both parties. The Ld. TPO; therefore, is directed to compute interest on outstanding receivable balances from the AE @ LIBOR + markup in accordance with the Rule 10CB of the Income Tax Rules. 1. ISSUES PRESENTED AND CONSIDERED 1. Whether the Transfer Pricing Officer (TPO) and Assessing Officer (AO) validly rejected the assessee's foreign associated enterprises (AEs) as the tested party for TNMM benchmarking where the assessee claimed it had provided sufficient financial data. 2. Whether the inclusion of impairment of intangible assets (R&D written off) and loss on sale/disposal of property, plant & equipment as operating expenses for computing OP/OR under TNMM was legally defensible. 3. Whether specific comparables (Flamingo Lifesciences Ltd. and Everest Organics Ltd.) were rightly included/excluded from the final comparable set for ALP determination. 4. Whether notional interest on overdue receivables from AEs constitutes a separate international transaction subject to benchmarking and, if so, the appropriate benchmark rate and methodology (including treatment of working capital adjustment, credit period, and LIBOR + markup). 5. Whether an adjustment made under processing u/s 143(1) read with ICDS is to be remanded for appropriate consideration by the AO. 6. Whether initiation of penalty proceedings under section 270A at the stage of the present appeal was premature. 2. ISSUE-WISE DETAILED ANALYSIS Issue 1 - Rejection of foreign AEs as tested party Legal framework: Selection of the tested party for TNMM must follow functional analysis (FAR) and the tested party is generally the less complex party for which the method can be most reliably applied; taxpayer must furnish necessary information about AEs so tax administration can verify selection and apply the method reliably. Precedent Treatment: The Court relied on OECD guidance (para 3.18-3.19) and UN Practical Manual on Transfer Pricing and followed prior Tribunal guidance requiring sufficient AE financial details; referenced decisions recognizing that foreign AE can be tested party if data suffices. Interpretation and reasoning: The Tribunal examined record and concluded the assessee failed to place requisite corroboratory documents demonstrating the AE's FAR and that AE was the least complex party. Absent sufficient financial data, reliable application and verification of TNMM was not possible. The Tribunal noted analogous authority where rejection was upheld for insufficiency of AE details and directed remand to enable assessee to substantiate AE as tested party with requisite data; TPO to re-examine reliability of method and comparability thereafter. Ratio vs. Obiter: Ratio - taxpayer must provide sufficient financial and FAR-supporting data to treat foreign AE as tested party; absence justifies rejection. Obiter - references to specific international guidance cited for illustration. Conclusions: Ground(s) challenging rejection of AEs succeed in part - issue remitted to AO/TPO with direction to allow assessee to substantiate AE as tested party; if substantiation fails, original comparables remain available. Issue 2 - Treatment of impairment of intangible assets (R&D) and loss on sale/disposal of PPE as operating expenses Legal framework: Operating expenses include costs directly related to normal business operations (including R&D where core to business); non-operating expenses relate to activities unrelated to core operations; accounting treatment and recovery through pricing relevant to TNMM PLI calculation. Precedent Treatment: Parties cited various Tribunal decisions on capital items and disposals; Tribunal distinguished those authorities on facts where prior decisions concerned revaluation or machinery accounting rather than R&D for product development. Interpretation and reasoning: The Tribunal found R&D expenditures (capitalized historically and written off in the year) were intrinsically tied to the core pharmaceutical manufacturing business and had not been previously charged to P&L; therefore such impairment represented operating cost that should be borne by product pricing and reflected in OP/OR. Conversely, loss on sale/disposal of PPE was held to be non-operating on the facts and excluded from operating expenses for ALP computation because such loss did not pertain to ordinary recurring costs of manufacturing/sales. Ratio vs. Obiter: Ratio - capitalized R&D impairment directly related to core business may be treated as operating expense for TNMM; loss on sale/disposal of PPE may be excluded as non-operating where factually unconnected to routine operations. Obiter - general accounting principles cited for context. Conclusions: Inclusion of R&D impairment as operating expense upheld (ground fails); inclusion of loss on sale/disposal of PPE as operating expense set aside and directed to be excluded (ground succeeds insofar as exclusion directed). Issue 3 - Inclusion/exclusion of specific comparables (Flamingo and Everest) Legal framework: Comparable selection must pass applied filters (functional similarity, export intensity, other filters); AO/TPO must reason functional dissimilarity where exclusion is asserted; operating turnover for export filter should exclude non-operating revenue. Precedent Treatment: Tribunal required reasoned demonstration of functional dissimilarity; export filter threshold applied to operating turnover. Interpretation and reasoning: For Flamingo Lifesciences Ltd., the AO/TPO/DRP did not adequately demonstrate functional dissimilarity; the Tribunal remitted the issue for fresh examination with opportunity to assessee. For Everest Organics Ltd., the assessee failed to show that it met the export filter (>=25% export of operating turnover); Tribunal accepted AO's exclusion after clarifying that operating turnover excludes non-operating revenue and sustained the AO's reasoning. Ratio vs. Obiter: Ratio - exclusions from comparable set must be supported by reasoned functional analysis; export filter applies to operating turnover (excluding non-operating items). Obiter - guidance on treating turnover components. Conclusions: Flamingo comparable issue remitted for reconsideration (ground succeeds limitedly); Everest exclusion upheld (ground fails). Issue 4 - Notional interest on overdue receivables from AEs: characterization, computation and rate Legal framework: Explanation to section 92B(2) and transfer pricing jurisprudence treat excessive receivables from related parties as equivalent to advances/loans constituting an international transaction; notional interest may be computed by benchmarking credit terms and interest rate. Rule 10CB and comparable precedents guide selection of market interest benchmark (e.g., LIBOR-based rates). Precedent Treatment: Tribunal followed decisions treating overdue receivables as international transactions and directing computation of notional interest (including use of LIBOR as appropriate benchmark) and referenced High Court and Tribunal authorities sustaining such approach. Interpretation and reasoning: Tribunal accepted that working capital adjustment does not subsume the separate effect of extended receivables where facts show benefit to AE by parking receivables; pattern of receivables required investigation and warranted separate benchmarking. The Tribunal held that overdue receivables should be benchmarked separately and directed TPO to compute notional interest at LIBOR + markup in accordance with Rule 10CB, remitting computation to TPO to apply correct LIBOR-based markup rather than the ad-hoc 400 bps as applied originally. Ratio vs. Obiter: Ratio - extended receivables from AEs can constitute a separate international transaction attracting notional interest; LIBOR-based benchmarks are appropriate subject to Rule 10CB; working capital adjustment does not automatically preclude separate interest adjustment. Obiter - comments on facts (average collection comparisons) and commercial practice. Conclusions: Grounds challenging characterization failed; TPO justified in treating receivables as international transaction. However, computation to follow Rule 10CB with LIBOR+ appropriate markup rather than ad-hoc approach; set-off for advance/early payments and detailed calculation to be addressed by TPO consistent with directions. Issue 5 - ICDS/processing adjustment under section 143(1) Legal framework: Adjustments under processing u/s 143(1) and ICDS may be subject to rectification or require AO reconsideration; procedural correctness in raising such issues at appellate stage may be constrained. Precedent Treatment: Tribunal observed procedural aspects but elected to remit for lawful decision by AO rather than decide issue on merits at appellate stage. Interpretation and reasoning: Although Revenue contended challenge should have been made at time of processing order, Tribunal remanded matter to AO to reconsider the processing/ICDS adjustment and allow if lawfully due, without deciding whether the appellate stage challenge was procedurally available. Ratio vs. Obiter: Ratio - where prima facie mistake appears in processing adjustment, AO should be directed to reconsider in accordance with law; procedural objections do not bar remand when adjustment appears amendable. Obiter - procedural posture commentary. Conclusions: Matter remanded to AO for lawful decision on ICDS adjustment (ground remitted). Issue 6 - Initiation of penalty proceedings under section 270A Legal framework: Penalty initiation may be premature if impugned assessments/adjustments are subject to ongoing proceedings. Precedent Treatment: Tribunal treated the point as premature. Interpretation and reasoning: The Tribunal dismissed ground on penalty as premature given pending adjudicatory steps. Ratio vs. Obiter: Ratio - initiation of penalty proceedings may be premature pending finalization of assessment issues. Obiter - none. Conclusions: Ground on initiation of penalty proceedings dismissed as premature. Disposition: The appeal was partly allowed for statistical purposes consistent with remittances and directions above.