DCIT, CIR. 1(1), KOLKATA vs. M/S KYOCERA CTC PRECISION TOOLS PVT. LTD., KOLKATA

Present for: Appellant by : Shri Rahul Saha, CA Respondent by : Shri G. Hukugha Sema, CIT, DR Date of Hearing : 22.05.2023 Date of Pronouncement : 02.06.2023 O R D E R

PER GIRISH AGRAWAL, ACCOUNTANT MEMBER:

by the revenue are reproduced as under: “1. That on the facts and circumstances of the Case, the Ld. CIT(A) has erred In deleting the Transfer Pricing adjustment of Rs.1,69,80,694 made on account of International AE transaction (purchase and sale) of the assessee.

2. That on the facts and circumstances of the Case, the Ld. CIT(A) has erred in relying upon the approach adopted by the assessee for capacity utilization adjusted PLI without the appropriate verification of all the relevant factual data for the comparable companies vis-a-vis the assessee.

3. That on the facts and circumstances of the Case, the Ld. CIT(A) has erred in not appreciating that the findings of the TPO is based on the unavailability of relevant financial data for comparable companies for allowing the appropriate capacity utilization adjustment.

4. That on the facts and circumstances of the Case, the Ld. CIT(A) has erred in not appreciating that, the Income Tax Act does not provide any standardized method to work out the capacity utilization adjusted PLI and, hence, the adjusted PLI arrived by the assessee needs strong documentary evidence on account of assessee as well as for comparable companies to substantiate its benchmarking, which is not available in the case of the assessee.

5. That the appellant craves leave to add to and/or alter, amend, modify or rescind the grounds hereinabove before or at the time of hearing of this appeal.”

3.1. All of the above grounds of appeal relate to allowing appropriate capacity utilisation adjustment while arriving at the Arms Length Price (ALP) of International Transactions of purchase and sale with Associate Enterprises (AE) of the assessee.

4. Brief facts of the case as culled out from records are that assessee is a joint venture between Kyocera Asia Pacific Pte. Ltd., Singapore (KAPPL) and CTC India Pvt. Ltd. (CTC).

Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16 Assessee is engaged in the business of manufacturing cutting tools such as inserts and holders to cater to the automotive industry and other industrial plants. Assessee entity was set up in June, 2012 which commenced its commercial operation in December, 2013. Accordingly, AY 2014-15 was the first year of its commercial operation containing broken period of the year. The impugned AY 2015-16 is the first year when operations took place for the full year. 4.1. Assessee has procured raw materials from both AE and non-AEs and processed them into finished products, part of which was supplied to its AEs. For the international transactions undertaken by the assessee with its AEs in respect of purchase and sale, assessee bench-marked the same by selecting Transactional Net Margin Method (TNMM) as the Most Appropriate Method (MAM) for which it carried out a transfer pricing study and furnished a Transfer Pricing Study Report (TPSR) placed on record. Based on the comparable analysis with the Indian Companies, assessee benchmarked its transactions. From its transfer pricing benchmarking exercise, the Net Profit Margin (NPM) with the comparable independent companies ranged from 3.20% to 6.14% and median of 4.91%, with Net Cost plus (NCP) the range was 3.30% to 6.54% with median of 5.16%. Assessee took NCP margins as its Profit Level Indicator (PLI) and by applying an adjustment towards its capacity utilisation, arrived at NCP margin of 11.66%. The final list of comparables taken by the assessee and those chosen by the Ld. TPO which have been considered for the purpose of Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16 bench marking are not in dispute in this appeal. Details in this respect are tabulated below:-

Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16 4.2 In respect of capacity utilisation of the assessee in the year under consideration, it is stated that it is at 34% as compared to 73% of the industry (manufacturing and automotive). To arrive at the industry average for capacity utilisation, assessee relied on industrial reports sourced from publication by Reserve Bank of India (RBI) and Federation of Indian Chamber of Commerce & Industry (FICCI) details of which are tabulated as under:

4.3. In the course of proceedings before the Ld. TPO, capacity utilisation adjustment made by the assessee while

Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16 benchmarking its international transactions was disregarded and adjustments were made by the Ld. TPO which is tabulated as under:

Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16 10B(1)(e)(iii) or in any other Rules of the Income-tax Rules, 1962 while working out the profitability parameters of an enterprise.

5.1. The observations made by Ld. CIT(A) on the above three broad aspects of the issue under challenge before us, are extracted as under:

5.1.1.Commercial aspect of effect of underutilisation of capacity upon the margin of the concern,

“By definition, capacity utilisation is the extent to which an enterprise actually uses its installed productive capacity. It is the relationship between actual output using the installed infrastructure, and the potential output which could arise, if capacity was fully used. Typically expressed as a percentage, this factor becomes an important comparability factor as it helps measure productive efficiency and cost efficiency. The costs incurred by any entity are of two types : variable costs which vary directly with the production level; and fixed costs which remain roughly at the same level irrespective of the production level. Since the variable cost varies directly with the production level, its recovery remains uniform irrespective of capacity utilisation, whereas the fixed cost which remains the same is under recovered as a result of under-utilisation of capacity – resulting in lower profitability. This brings us to the reasons why it is important to take into account capacity utilisations in evaluating the margins or profitability of an enterprise – this, of course, is without reference at the moment to Income Tax considerations. It is common knowledge and the phenomenon of low capacity utilisation is commonly noticed across manufacturing companies during their start-up phase. While the variable costs are incurred and recovered in tandem with the quantity produced, it is the fixed costs that are incurred at the beginning and continue to be incurred irrespective of the actual level of production. In such cases, companies generally incur losses or make nil or negligible profits owing to their huge investments in fixed costs, which cannot be fully recovered until the capacity is fully utilised. In the light of such under-utilisation of installed capacity, it becomes clear that the margins earned by the assessee are not in the regular course of business and not comparable, as Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16 such, with similar companies in the industries unless adjusted for. An added feature that points towards the fact that if a meaningful evaluation of the performance of a company has to be undertaken in terms of margins, profitability etc, then we find that without providing for the adjustment of under-utilised capacity, a company would appear to have understated its operating margins (in the case of the appellant this has led to the declaring of an operating loss) during such period. However, on adjusting for the capacity difference with respect to industry capacity in a systematic manner, it can lead to the clearer scenario where fixed costs are proportionately reduced to present a better picture of the actual operating economic conditions of the appellant. It is quite clear from the discussions above that without taking into account the effects of capacity under utilisation and any adjustments concomitant with such effects, any evaluation of the efficiency, margins or profitability, or indeed the very working environment peculiar to the particular company cannot be sensibly undertaken at any point of time. The Hon'ble High Court of Karnataka, in the case of The Commissioner of Income Tax-8 Vs. Petro Araldite Pvt. Ltd. (ITA No. 1540 of 2014), has explained this issue in the following terms. " ... The impugned order of the Tribunal records that the difference in capacity utilisation would affect the profit margin of a manufacturing concern. It points out that the fixed overheads of any manufacturing concern will be constant, irrespective of the capacity utilisation. Thus, the profit margin would be affected on account of the difference in capacity utilisation. Less utilisation of capacity, would result in allocation fixed costs over a smaller number of final products. Thus, reducing the profit margin." (emphasis added) Having thus accepted that the effects of capacity under- utilisation are an integral, indispensable and important part of the analysis of the economic/commercial working environment of an Assessee company, we find that in the instant case such an environment of capacity under- utilisation did indeed undisputedly exist during the impugned period on account of its initial stages of operation and the discussions, in relation to the installed and utilised capacity, above.”

5.1.2.Whether adjustment based on the fact of capacity under utilisation have any justification, roots or sanction in the various judicial precedents or not.

Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16

“The appellant, in this connection, has cited numerous case laws and judicial precedents that have underlined the need for adjustments based upon capacity under-utilisation or taking into account issues related to differentials in capacity utilisation. I have carefully studied the various judicial pronouncements cited by the appellant in this regard. Some of these are being discussed as under:

(a) The High Court of Karnataka, in the case of Pr. Commissioner of Income Tax-7 & Anr. Vs. M/s. Sami Labs (I.T.A. No. 291/2017), held that: "... We have heard the learned AR as well as the learned DR and considered the relevant material on record. The Tribunal for the Assessment Year 2009-10 has directed the AO/TPO/AO to consider the claim of the assessee for the purpose of giving adjustment on account of low capacity adjustment. We make it clear that the adjustment is only on account of cost attributable to idle capacity for the year under consideration. Accordingly, the assessee has to provide all the details of capacity utilisation of assessee as well as comparable for computation of adjustment, if any.” (b) The Coordinate Bench of ITAT, Kolkata in the case of Witzenmann India Pvt. Ltd. Vs. DCIT (2023) 148 taxmann.com 116 (Kol) has held that capacity utilisation had a co-relation with profits earned by the company since it leads to under-absorption of fixed costs and level of working capital have an impact on the prices charged and profits earned by Company. Claim of adjustment in respect of capacity utilisation and working capital levels should be considered after taking into account detailed working given by the assessee. The observation and finding given by the Co-ordinate Bench in para 12, 13, 16 and 17 are reproduced for ready reference (undersigned Accountant Member is the author for this decision):

Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16 “12. From the above submissions and material placed on record, it is undisputed that assessee has utilized only 22% of its installed capacity in the year under consideration. It is also evident that the comparables are at higher levels of capacity utilization. These f acts are incorporated in the tables reproduced above. We note that capacity utilization has a co-relation with the profits earned by a company since it leads to under-absorption of fixed cost, more particularly when the MAM selected is TNMM. Further, we note that FATR is not an indicator of capacity utilization of a company. In respect of working capital adjustment, we note that it is undisputed that assessee has a lower level of working capital as compared to the comparables. Admittedly, levels of working capital have an impact on the prices charged and the profits earned by a company. In respect of the above two adjustments, we note that it would be against the TP regulations and guidelines enumerated above to compare the profits earned without making these economic adjustments.

Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16 16.1 Working done by the assessee in respect of two above stated adjustments is based on three comparables out of those selected by the Ld. TPO and four comparables out of those selected by the assessee. Since the grounds taken by the assessee on the selection of comparables by the Ld. TPO is not pressed upon in the instant appeal and the categorical finding of the Ld. CIT(A) on the same holding the selection of comparables by Ld. TPO as undisturbed, we find it proper to direct the Ld. TPOI AO to consider the claim of adjustment in respect of capacity utilization and working capital levels so as to allow adjustment to the profit margin on comparables selected by him (TPO/AO), after affording the assessee reasonable opportunity of being heard. 16.2 In a situation where the data about comparable companies is not available f or the purpose of allowing adjustments towards capacity utilization and working capital levels, the only way to get the data in a current case would be by Ld. TPO collecting the same from the comparable companies so selected by him by exercising his powers U/S 133(6) of the Act. For this proposition, reliance is placed on the decision of Coordinate bench of ITAT, Mumbai in the case of ft. CIT v. Kiara Jewellerv (P.) Ltd. (2014) 45 taxmann.com 548/[2015] 152 ITD 891 wherein the TPO/AO was directed to obtain the exact details on capacity utilization of comparable companies, if not available in public domain. The relevant extract of the aforesaid decision is as under: "11. Keeping in view the decision of the Tribunal in the case of Petro Araldite (P.) Ltd. (supra) laying down the guidelines on the issue of capacity utilization, we consider it appropriate to restore this issue relating to adjustment on account of capacity utilization in the case of assessee company to the file of AO/TPO for deciding the same afresh keeping in view the said guidelines. If the exact details of capacity utilization of the comparable companies are not available in the public domain, the AO/TPO is directed to obtain the same directly f rom the concerned parties and to decide this issue afresh after giving assessee an opportunity on being heard."

Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16

(c) Assessee has placed on record a compendium of case laws, most of which have been discussed by the Ld. CIT(A) while dealing on this aspect. The table of cases is reproduced for ease of reference:

Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16 5.1.3.Whether there is an express embargo upon the making of capacity utilisation adjustment with Rule 10B(1)(e)(iii) or in any other Rules of the Income-tax Rules, 1962 while working out the profitability parameters of an enterprise:-

“Coming finally to the third part of this discussion on whether there is an express embargo upon the making of capacity utilisation adjustments within Rule 10-B(1)(e)(iii) or in any other of the rules of the Income Tax Rules, 1962, while working out the profitability parameters of an enterprise. This question as mentioned above, has other associated limbs to it. The question that needs to be addressed is whether the concept of capacity utilisation can be read out of the provisions of the Income Tax Act or Rules thereof. More precisely, for the present context, can it be said that if a significant difference in capacity utilisation exists in the case of the tested party - as in this case - and the capacity utilisation of uncontrolled parties, then it is essential, for a harmonious and meaningful reading of the relevant provisions of the Rules, to include the effect of capacity under-utilisation on the margins or profitability of the tested party in the working out of comparisons between the tested party and the uncontrolled comparables and whether it can be construed that Rule 10-B(1) (e) (iii) of the Income Tax Rules, 1962 allows for such adjustments. We have already seen from the aforesaid discussions that this question has already been answered in the affirmative in the plethora of judicial pronouncements cited and discussed above, wherein the judicial authorities have sanctioned, in fact, mandated, the factoring in of the effect of under-utilisation of capacity in cases where comparisons are to be made with well

Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16 established uncontrolled concerns. This, it has 'been stated, is for providing a suitable and realistic baseline for the margins/profitability of the tested party that is in a phase of underutilisation of capacity. Let us now take a closer look at the relevant Rules themselves. Before looking at the issue of adjustment for difference in capacity utilisation, it is necessary first to see the procedure laid down for carrying out the exercise of comparability analysis and for making suitable adjustments. This procedure, as laid down in section 92-C of the Act, provides that the ALP in relation to an international transaction shall be determined by any of the methods specified therein, being the most appropriate method and the manner in which the said ALP has to be determined is given in section 92-C(2) of the Act read with Rule 10B of the Income Tax Rules, 1962 in respect of each method .separately. Clause (e) of Rule 10-B stipulates the manner in which the ALP in relation to an international transaction is to be determined by following the transactional net margin method. The same is reproduced as under: "(e) transactional net margin method by which- i)the net profit margin realised by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise. or having regard to any other relevant base; - ii) the net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base; (iii) the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market; (iv) The net profit margin realised by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii); (v) The net profit margin thus established is then taken into account to arrive at an arm's length price in relation to the international transaction;" A plain reading of the above rule clearly brings to fore the fact that while relying upon the TNMM method, the legislature has envisaged the necessity of bringing a tested party on to the same footing as the uncontrolled comparables and for that purpose

Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16 prescribed the making of suitable adjustments in the net profit margins in order to create a common baseline for making the comparisons between the tested party and the uncontrolled com parables. Sub-clause (iii) above clearly mandates the making of adjustments to net profit margins to take into account factors " ... which could materially affect the amount of net profit margin in the open market." The above discussions, relating to the operating business environment of the tested party, as well discussions related to the judgments in this regard have clearly established that capacity under-utilisation is undisputedly a factor that would materially effect the net profit margins of an capacity underutilising entity. Therefore we are led to the conclusion that since capacity utilisation is undisputedly a factor which materially effects margins and profitability, it can be construed that there would be no contradiction or unlawfulness in using it to arrive at a sensible comparison as envisaged in Rule 10B(e) and specifically within the meaning of subclass (iii) of the said clause of the sub-rule. Once the matter that there is nothing materially wrong or unlawful with the appellant's approach of making adjustments for capacity under utilisation is settled as per the above discussions, the next question that arises is, in view the aforesaid provisions of the relevant Rule, how and to what extent the difference in capacity utilisation affects the profit margin and how the adjustment on account of difference in capacity utilisation can appropriately be made. This question, naturally, has to be answered within the framework of Rule 10B - that being the governing Rule for addressing such issues. I have examined the appellant's submissions in this regard and find that some possible approaches to implement capacity utilisation adjustments areas under: • Approach 1: Adjusting fixed costs of the tested party, keeping sales and variable costs unchanged; • Approach 2: Hypothesising sales and variable costs of the tested party to the optimum level of utilisation, keeping fixed costs constant; and • Approach 3: Adjusting the profit margin of the com parables by absorbing depreciation of the comparables at same rate at which depreciation is absorbed by the tested party (based on guidance provided by the Mumbai bench of the Income Tax Appellate Tribunal in the Fuchs Lubricants ruling). Since the data pertaining to capacity utilisation of comparables is not available in the public domain, the only plausible option for making adjustments would be to follow Approach 1, were the tested party data is adjusted for capacity under-utilisation. Since variable costs is usually in proportion to the actual utilisation or production, no adjustments would be required to be made to the Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16 same. It is only the fixed cost that continues be incurred in full. It is this cost that remains a constant right up to the time that full capacity established. With reference to the above discussions in this context and the judicial pronouncement in this regard, it is clear that it is in the incurring of these fixed costs that adjustments have to be made in relation to the actual utilisation.”

5.2. For the purpose of making adjustment on account of under-utilisation of capacity, assessee has submitted its working by adopting the two options i.e. first being adjustment on the fixed cost with capacity under-utilisation of tested party at 34% and the second being adjusting the revenue and variable cost assuming that tested party was operating at the industry capacity utilisation levels of 73.19%. Both the options would give the same result on the adjusted margin which is tabulated as under:

Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16 5.3. By analysing the above three aspects exhaustively, Ld. CIT(A) arrived at a conclusion to allow for the capacity utilisation adjustment for the purpose of benchmarking and deleted the addition made in this respect. Aggrieved, revenue is in appeal before the Tribunal.

Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16 He referred to Rule 10B of the Income-tax Rules, 1962 (hereinafter referred to as the “Rules”) clause (e) sub-clause (iii) which provides that the net profit margin is to be adjusted to take into account the difference , if any, which could materially affect the amount of net profit margin in the open market. He further pointed to the said rule to submit that an uncontrolled transaction shall be comparable, if reasonably accurate adjustment can be made to eliminate the material effects of differences, if any, between the transactions being compared.

7.1. According to the Ld. Counsel, guidance note on report u/s. 92E of the Act issued by Institute of Chartered Accountants of India (ICAI) also provides guidance and lists down specific entries which may affect the net margins and includes adjustment in respect of difference in the capacity utilisation level. He also referred to the transfer pricing guidelines for Multinational enterprise and Tax Administration by the OECD wherein at para 2.76, difference in capacity utilisation has been considered wherein it is stated that the transactional net margin method may be more sensitive than the cost plus or resale price methods to differences in capacity utilisation, because differences in the levels of absorption of indirect fixed costs (e.g fixed manufacturing cost or fixed distribution costs) would affect the net profit indicator but may not affect the gross margin or gross mark-up on costs if not reflected in price differences. He also referred to an important fact of start-up phase which has led to the adjustment for capacity utilisation in contrast to the year of incorporation of Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16 comparables which has been tabulated to demonstrate that their operations had commenced much before the assessee was even incorporated. The table is reproduced as under:

7.2. He thus, emphasized that assessee has artificially made an adjustment towards its capacity utilisation being in start up phase, more particularly when the impugned year is the first full year of its manufacturing operation.

Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16 The comparables as tabulated above have commenced their operations much earlier to the assessee and are better placed towards their capacity utilisation. The capacity utilised by the assessee during the year under consideration at 34% is also not in dispute. The industry average of capacity utilisation in the segment to which the assessee belongs, is 73.19% and has also been not controverted.

8.1. On an absolute basis, assessee is in the loss scenario, in the year under consideration. However, when capacity utilisation adjustment is made for the purpose of transfer pricing benchmarking of its international transactions with AEs its NCP margin comes to 11.66% which is comparable to the Indian comparable companies. What the Ld. TPO has done is that capacity utilisation adjustment made by the assessee has been disregarded and has arrived at the TP adjustment of Rs.1,69,80,694/-. From the perusal of records and material before us, assessee had adequately demonstrated from the data and the details, about the computation of the adjustment arrived at towards capacity utilisation.

8.2. Further, Ld. CIT(A) has elaborately dealt with the three aspects of the issue in hand before us which has been extracted above. The three aspects analysed by Ld. CIT(A) deals with the data and the computation mechanism adopted for the purpose of arriving at the adjustment, the judicial precedents which supports such adjustment and the various regulations in the law and other supporting documents, all of which convince us to hold that capacity utilisation

Kyocera CTC Precision Tools Pvt. Ltd. AY: 2015-16 adjustment is a permissible adjustment vis-à-vis the comparables. We do not find any reason to interfere with the well reasoned findings given by the Ld. CIT(A) in upholding the capacity utilisation adjustment made by the assessee and deleting the adjustment made by the Ld. TPO/AO in this respect. Accordingly, grounds taken by the revenue are dismissed.