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Income Tax Appellate Tribunal, “C” BENCH : BANGALORE
Before: SMT. BEENA PILLAI & Ms. PADMAVATHY S
Per Padmavathy S., Accountant Member
This appeal is against the final order of the AO passed u/s. 143(3) r.w.s. 144C(13) of the Income-tax Act, 1961 [the Act] dated 28.6.2019 for the assessment year 2007-08 on the following grounds:-
1. That the order of the Ld. TPO and the order of the Honourable DRP in pursuance of whose directions, the said assessment order is passed insofar as it is prejudicial to the interests of the Appellant are opposed to law and facts of the case.
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2. That in the calculation of Operating Margin of the Assessee, the Hon'ble DRP erred in not directing the Ld TPO to exclude the abnormal cost incurred on raw materials by the Assessee during the relevant assessment year, which is the first active year of operation.
3. That the Hon'ble DRP erred in sustaining the order of the Ld.TPO by including M/s Mazda Ltd as a comparable without appreciating the fact that the products manufactured by the said company is entirely different form that manufactured by the Appellant. 4. That in computation of ALP, the Hon'ble DRP erred in not directing the Ld TPO to include M/s Leader Valves as a comparable even though the company is in the same industry as that of the Assessee. 5. That the Hon'ble DRP erred in sustaining the order of Ld TPO by including M/s. Yuken India Limited as comparable and in doing so it failed to appreciate that the valves manufactured by the comparable company is only one of the product in the products list, and no separate figures for the relevant segment are available in the Annual report of that company. 6. That in the Computation of the ALP, the Hon'ble DRP erred in not directing the Ld. TPO to consider the adjustments to the respective Working Capital position of the Appellant and the Comparable Entities. 7. The Hon'ble DRP erred in sustaining the order of Ld TPO in respect of interest paid on ECB's and in doing so it failed to appreciate that the Ld TPO misdirected himself in not considering the rate of interest permitted by RBI as the ALP.
The assessee is a wholly owned subsidiary of Walvoil Group SpA, Italy and is engaged in the manufacture of Hydraulic valves and components used mainly in the construction and earth moving segments. The assessee company filed its return of income on 30/10/2007 declaring total loss of Rs. 5,15,43,599/- for AY 2007-08. The case was selected for scrutiny. The AO referred the case to Transfer Pricing Officer (TPO), as assessee 's international transaction exceeded Rs. 15 crore to determine the Arm's Length Price [ALP]. The TPO vide his order dated 19/10/2010 made an adjustment to the extent
IT(TP)A No.1839/Bang/2019 Page 3 of 28 of Rs. 2,75,21,212/- in the ALP in respect of Manufacturing segment, ECB interest paid and fee for technical services. Based on TPO's order, the AO passed a Draft Assessment order dated 22.11.2010 u/s. 143(3) r.w.s 144C of the Act incorporating the adjustment to the ALP. The assessee filed its objections before the DRP and the DRP confirmed the additions made by the AO/TPO. Consequently, the AO passed assessment order u/s. 143(3) r.w.s 144C of the Act. Aggrieved by the final assessment order the assessee filed appeal before the Tribunal. The Tribunal vide order dated 05.08.2016 in IT(TP)A No.1075/Bang/2011 set aside all the grounds including the additional grounds raised by the assessee company to the file of TPO to decide the issues afresh in accordance with law.
In the remand proceedings the TPO vide order u/s 92CA r.w.s 254 of the Act dated 12/10/2018 determined Rs. 2,19,73,114/- as total adjustments to the ALP. The assessee went to DRP against the adjustment made by TPO. Meanwhile, the assessee filed rectification application before TPO on 05.11.2018 and consequently the TPO has passed the order u/s 154 dated 22.01.2019 reducing the TP adjustment from Rs. 2,19,73,114/- to Rs. 1,40,13,901/-. The DRP vide its order dated 23.05.2019 rejected the grounds of the assessee relating to Transfer Pricing issues. The assessee is now in appeal before the Tribunal against the final order of the AO passed as per the directions of the DRP in the second round. We will adjudicate the issues raised in the grounds by the assessee in the following paragraphs.
IT(TP)A No.1839/Bang/2019 Page 4 of 28 Exclusion of abnormal raw material consumption
The assessee made an adjustment of 18% towards abnormal raw material consumption during the AY 2007-08 as it is the first full year of operation of the company. The TPO while considering the issue during the remand proceedings did not allow the adjustment for the purpose of computation of ALP. The DRP was of the view that this claim was not made by the assessee in the first round and the assessee cannot raise this plea in the second stage of proceedings, as the TPO cannot travel beyond the scope of boundaries in the set aside proceedings. On merits, the DRP rejected the claim of the assessee on the ground that consumption of raw material in subsequent years is not coming down in the linear method and in fact rising in the FY 2009-10. The DRP also analysed the scrap sale of the assessee from AY 2007-08 to 2010-11 and was of the view that it did not support the claim of the assessee for an adjustment. Aggrieved, the assessee is in appeal before the Tribunal.
The ld. AR has filed written submissions the extract of which is given below :-
(i) It is submitted that the year under appeal is the first year of full commercial production and during this year the company carried out certain trial productions which resulted in abnormal scrap and wastage of material. It is submitted that in a TP study when the net margins of the comparables are determined, it is to be ensured that all the comparables are reduced to a common denominator to enable
IT(TP)A No.1839/Bang/2019 Page 5 of 28 the Assessing authority to determine whether the tested entity's margins are as per the industry norms. If either the tested entity or any comparable is subject to an exposure that would have materially affected its profitability, then a suitable adjustment would have to be made. In the present case, it is a fact that the year under appeal was the first year of production and assessee was still in the process of establishing its market in the country which involved initial cost of distribution, travelling expenses, meeting new customers and making the products known, which itself resulted in excess expenditure. The products themselves were being manufactured in the factory for the first time and naturally there were wastages and scrap. This is only a question of fact and there is no question of law involved.
(ii) Further, Rule 10B itself categorically provides that an adjustment ought to be provided for any differences in the economic factors and circumstances under which the tested party and the comparables are operating. In the instant case, the assessee is being compared with companies which have been in the market for decades altogether while the assessee itself was in the very first year of commercial production. The fact that once the production stabilised, the assessee was able to show improved productivity can be seen from the table given below:-
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Assessment Year Particulars 2007-08 2008-09 2009-10 2010-11 Sales & other related income 15,32,28,023 42,79,34,852 44,61,99,700 44,78,88,654 Material consumption 13,47,44,093 30,56,52,601 30,49,51,994 33,77,07,924 Percentage % 88% 71% 68% 71% Average of AY 2008-09, 2009-10 & 2010-11 70% Percentage of raw materials allowance 18% claimed by the appellant
(iii) From the above, it was submitted, it can be seen that average material consumption to sales declined by about 18% from the second year onwards. Based on the above, it is prayed to direct the AO to consider an allowance of 18% to the margins of the assessee in arriving at the ALP.
The ld. DR submitted that this is a fresh adjustment made by the assessee during the remand proceedings and the TPO/DRP were right in rejecting the adjustment as this issue was not before the Tribunal in the first round and hence the TPO cannot travel beyond the scope of the set aside proceedings. The ld. DR supported the findings of the DRP on merits of the issue and submitted that the financial of the subsequent years are not filed by the assessee to substantiate its claim that the raw material consumption was abnormal during the AY 2007- 08 alone.
We have considered the rival submissions and perused the material on record. The assessee was incorporated during 2005 and FY 2006-07 (AY 2007-08) is the first full year of operation. The IT(TP)A No.1839/Bang/2019 Page 7 of 28 assessee is in the business of manufacture of hydraulic valves for automobiles and industrial machinery, which according to the assessee, is a highly competitive market. The assessee imports raw materials from its AE and exports the finished products to the AE. The ld. AR drew attention to the comparative percentage material consumption on sales of the comparables at page 21 of the PB, which is extracted below:-
COMPARITIVE PERCENTAGE OF MATERIAL CONSUMPTION ON SALES Mazda Yuken India LeaderValves Walvoil (Tested entity) Particulars Ltd Ltd Ltd AY 2007-08 AY 2007-08 AY 2007-08 AY 2007-08 AY 2008-09 AY 2009-10 AY 2010-11 Sales & other related 52,51,30,950 85,09,81,501 49,77,14,400 15,32,28,023 42,54,82,852 44,61,95,510 47,72,90,378 income Material consumption 33,76,92,904 48,76,30,251 15,39,86,720 13,47,44,093 30,56,52,601 30,49,51,994 33,77,07,924 64% 57% 31% 88% 72% 68% 71% Percentage - % 70% Average
The DRP’s observation with regard to scrap sale is relevant as one of the contentions of the assessee for higher material cost is the wastage of raw material in the initial years of operation. We notice that the raw material consumption is not reducing in a linear manner as claimed by the assessee warranting an adjustment for the purpose of ALP. Further, this adjustment is done by the assessee during the remand proceeding as a new adjustment to the ALP and from the order u/s.92CA passed by the TPO it is not coming out clearly whether this adjustment is examined in detail during the remand proceedings by the TPO. One of the reasons quoted by the DRP for rejection of this IT(TP)A No.1839/Bang/2019 Page 8 of 28 .>. adjustment is that the assessee has not submitted the annual reports of the subsequent years to substantiate the raw material consumption details. The raw material consumption is unique to each business and depends on many factors including internal and external factors like location, environment, etc. and needs to be examined factually based on evidences and supporting. In view of the above discussion we remit this issue back to TPO/AO to examine the issue afresh and pass a speaking order after giving a reasonable opportunity of being heard to the assessee. The assessee is directed to submit all the relevant details and evidences as may be called for in this regard and cooperate with the proceedings. It is ordered accordingly. This ground is allowed in favour of the assessee for statistical purposes.
Exclusion of certain comparables
The assessee in the TP study had selected 10 comparables for arriving at the conclusion that the transactions with the AE is at arm’s length. The TPO rejected 9 out of 10 companies and added one more comparable to arrive at the arithmetic mean as under:-
(Data used 31.03.2007) Rs. in Crores Sl. Name of the Company Operating Operating Operating Op. Profit/ Op. Profit/ No. Revenue Cost Profit Cost% Sales% 1. Mazda Ltd. 8.62 7.66 0.96 12.53% 11.14% (Segmental ) 2. Yuken India Ltd. 100.15 86.29 13.86 16.06% 13.84% (Tax payer's ) Arithmetic Mean. 12.70% 12.49%
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During the remand proceedings, the assessee made submissions before the TPO based on fresh search to include one more comparable i.e., M/s. Leader Valves. The assessee also submitted that the companies included in the original assessment i.e., Mazda Ltd. & Yuken India Ltd. need to be excluded as they are functionally not comparable. Without prejudice the assessee submitted the revised financials of operating revenue and operating cost of Yuken India Ltd for the consideration of the TPO in case the company is included as a comparable. The TPO rejected the assessee’s contentions with respect to inclusion and exclusion and retained the original comparables. However, he took into account the revised operating revenue and operating cost of Yuken India Ltd. to recompute the TP adjustment.
11. Before the DRP, the assessee objected to the decision of the TPO to include M/s Mazda Ltd and Yuken India Ltd and also the exclusion the new comparable M/s. Leader Valves added by the assessee during remand. The DRP stated that TPO rejected the fresh TP study report provided by the assessee as TPO was not in agreement with the filters applied by the assessee and that in the revised TP study the assessee came up with only one comparable as the assessee prayed for exclusion of the original comparables chosen. The DRP concluded with the following observations on the inclusion / exclusion of the comparables:-
“The TPO's study resulted in two comparables one being M/s. Mazda Ltd. The comparable is into manufacture of engineering goods like vacuum products and valve products (as per para 6 of annual report). The assessee is into manufacture of Hydraulic
IT(TP)A No.1839/Bang/2019 Page 10 of 28 components and fluid power products. He noted that the product range of both are broadly similar being engineering products involving vaccum fluid and valve products. The assessee argued that only one range of products i.e., control valves with turnover of Rs.I.07 crore is similar. However, from para 6 of the Annual report the DRP found that valve segment turnover is Rs.8.16 crores out of Rs.52 crores. Even otherwise apart from valves, other products (vacuum products) are also very similar. According to the DRP, under the TNMM method, there is no requirement of product identity for comparability and broad product range comparability would be sufficient. Hence the arguments put forth by the assessee were rejected”. “The assessee objects to the inclusion of the comparable M/s Yuken India Ltd. stating that this company manufactures Hydraulic pumps, valves and other products. The assessee admits that valves are same products like that of assessee but argues that in the absence of segmental data this company should not be accepted. The contentions of the assessee are examined carefully. Hydraulic pumps manufactured by the comparable company are very similar to assessee's hydraulic products and fluid power products. The TPO in his order dated 19.10.2010 at para-3 has clearly identified the product line of assessee as (1) Hydraulic components and (2) Fluid power products. Segmental results are not required when overall range is very similar. Hence there is no merit in assessee’s argument.” “The assessee contents that M/s Leader Valves should be included as comparable as it is having similar products line. However it is seen that assessee is proposing this comparable for the first time before DRP and this ground was not taken in the first round even before ITAT. The grounds referred by the ITAT to the TPO does not include this comparable. Further it was never a comparable in the assessee's study also. There is no evidence that it passed the filters applied by TPO and it is not part of TPO search matrix. Hence there is no merit in the argument put forth by the assessee.”
12. Before us, the ld. AR submitted that :-
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Mazda Limited is an engineering company having one of the largest number of steam jet vacuum system and condensers sold for the process of power industry. This company specialises in supplying equipment to various Industries like Power, Chemicals, Bulk Drug Industries and also caters to needs of Refineries, Sugar and Food industries. These devices are used in Jets and have no connection with the products manufactured by the assessee. Accordingly, it is prayed that this company may be excluded.
Yuken India Ltd is a manufacturing company which manufactures Hydraulic Pumps, valves and other products. The valves produced by this company is similar to the assessee, however, the annual report of the company does not contain segment wise details of manufacture and sale of valves. In the absence of these details, this company cannot be taken as comparable. Accordingly, it is prayed that this company may be excluded.
Leader Valves Ltd. - It was submitted that the ITAT had set aside the entire issue to the TPO. Accordingly, the assessee made a fresh search for comparables by applying the filters in search matrix and two final comparables were taken. During the proceedings before the TPO, the Assessee had accepted that one of the companies was too small and had substantial trading activity also and agreed for its exclusion. Accordingly, only one company namely Leader Valves Ltd was contended to be included. This company is engaged in the IT(TP)A No.1839/Bang/2019 Page 12 of 28 manufacture of fluidic piping systems and valves and forged steel gate valves and similar products.
The ld AR further submitted that in the assessee’s own case for AY 2013-14, the ITAT has held that as opposed to other transfer pricing methods, the TNMM requires transactions to be "broadly similar" to qualify as comparable. "Broadly similar" in this context means that the compared transactions don't have to be exactly like the controlled transaction. This increases the amount of situations where the TNMM can be used and thus TNMM is the most commonly used methodology applied and accepted for determining the ALP. When TNMM is used for determining the ALP, it is not necessary for the comparable company and the taxpayer to cater to the same industries in order to be functionally comparable. Further TNMM does not require strict product comparability. Since, Leader valves Ltd conforms to these requirements, it is submitted that the same may be included.
14. The ld. DR made the following submissions :-
“The DRP has held that Transfer pricing is not an exact science and the TPO and the Assessee have to make the TP analysis depending on the prevailing economic conditions and circumstances in each year. This is because the dynamics and profile of business keep on changing year on year. Therefore the TPO may not be in a position to directly apply the findings of the ITAT regarding comparables in earlier year to the current year. Further the DRP held that Rule 10B provides for making reasonably accurate adjustment to the uncontrolled comparable transaction to eliminate the material effects of differences on the price, cost or profits. The working capital requirements and impact depends on various factors such as business cycles, the nature of business activity with its correlation on the general
IT(TP)A No.1839/Bang/2019 Page 13 of 28 economic trends, the fund and capital position of the company, its marketing strategies, its market share etc., all of which cannot be captured in the year end Receivable and Payable position. Further, the assessee had failed to demonstrate such material differences so as to warrant an adjustment and the DRP upheld the TPO's reasoning.” 15. The ld. DR supported the order of the DRP and submitted that the assessee's ground may be dismissed.
We have considered the rival submissions and perused the material on record. The assessee followed TNMM as the Most Appropriate Method [MAM] for the determination of ALP. The coordinate Bench of this Tribunal in the assessee’s own case for AY 2013-14 in IT(TP)A No.1901/Bang/2017 dated 21.3.2022 has discussed in detail about the principles relating to TNMM which is extracted below:-
“19. Before going into the merits of this case, we will first look into the legal position with regard to the TNMM used for determining the ALP between the AEs. The Transfer Pricing Regulations (i.e. Section 92C of the Act, read with rule 10B of the Income-tax Rules) as well as the OECD Transfer Pricing Guidelines provide the 5 common transfer pricing methods for evaluating the related party transactions undertaken between entities. Of these TNMM is the most common method that is used for determining the arm's length nature of transactions. It compares the operating/ net margins of companies to analyse if the related party transactions have been undertaken on an arm's length basis. Rule 10B (1) (d) states as under: "10B . (1) For the purposes of sub-section (2) of section 92C, the arm's length price in relation to an international transaction [or a specified domestic transaction] shall be determined by any of the following methods, being the most appropriate method, in the following manner, namely :—
IT(TP)A No.1839/Bang/2019 Page 14 of 28 ** ** ** (e) transactional net margin method, by which,— (i) the net profit margin realised by the enterprise from an international transaction [or a specified domestic 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 [or the specified domestic 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 [or the specified domestic transaction] ;"
20. Under TNMM, the net profit of a controlled transaction of an associated enterprise (tested party) is determined and this net profit is then compared to the net profit realized by comparable uncontrolled transactions of independent enterprises. As opposed to other transfer pricing methods, the TNMM requires transactions to be "broadly similar" to qualify as comparable. "Broadly similar" in this context means that the compared transactions don't have to be exactly like the controlled transaction. This increases the amount of situations where the TNMM can be used and thus TNMM is the most commonly used methodology applied and accepted for determining the ALP.
IT(TP)A No.1839/Bang/2019 Page 15 of 28 When TNMM is used for determining the ALP, it is not necessary for the comparable company and the taxpayer to cater to the same industries in order to be functionally comparable. Further TNMM does not require strict product comparability. Therefore we are of the considered view that that the contention of the assessee that the products of Trion Valves and the industry to which Triton Valves serve are not comparable with assessee is not tenable as the most appropriated method as chosen by the assessee for determination of ALP is TNMM.”
Considering the above, we will now look into the inclusion and exclusion of comparables sought by the assessee.
18. The overview of business of Mazda Ltd. shows that it a manufacturing and engineering company mainly into space and energy saving ejector vaccum systems. The product catalogue of the company includes vaccum systems, condenser, heater vaccum pump, hotshot pump, etc. One of the products manufactured is the value and the company in its annual report has given the financials of the valve product separately. We notice that the TPO has for the purpose of comparability considered the revenue and cost attributable to value products only. The level of comparability under TNMM is at a broad level of product comparability and high level functional comparability. Therefore, in view of this discussion and following the decision of this Tribunal in assessee’s own case (supra), we hold that Mazda Ltd. cannot be excluded and the orders of the lower authorities are upheld.
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This company is included by the assessee in its TP study and it was not contended in the first round of proceedings. However, during the remand proceedings, the assessee has sought for its exclusion before the TPO on the basis that the list of items manufactured by the company includes products that are not similar to that of that of the assessee and the segmental profit with respect to values product similar to the assessee is not available for comparability. The TPO rejected the contention of the assessee and retained its inclusion. The DRP held that products line of Yuken India Ltd. is similar to that of the assessee i.e., hydraulic components and fluid power products and therefore there is no requirement for a segmental comparison, when the overall product range is very similar. Following the decision of this Tribunal in assessee’s own case (supra), we hold that Yuken India Ltd. is having a broad level of product comparability and high level of functional comparability and rightly included in the list of comparables by the revenue authorities. This issue is decided against the assessee.
Inclusion of M/s. Leader Valves
During the course of remand proceedings, the assessee did a fresh search of comparables and submitted that the list of comparables before the TPO which included this company, Leader Valves. The TPO rejected this comparable. The DRP also rejected it stating that this ground was not before the TPO or the ITAT in the earlier proceedings and no evidence as to how this comparable was chosen
IT(TP)A No.1839/Bang/2019 Page 17 of 28 was furnished before the TPO. We notice that Leader Valves Ltd. is involved in manufacturing of industrial valves, coils, boiler mounting and forge fittings. The range of products include gun metal/bronze valves, cast steel valves, forged steel valves, cast iron valves, boiler mounting valves. The company serves industries in oil & gas, power, marine & water, steel & mining, chemical & fertilizres, HVAC, etc. Applying the principles laid down by the Tribunal in assessee’s own case (supra), we are of the considered view that Leader Valves Ltd. should be included as a comparable, considering the broader product comparability and high level of functional comparability. As regards the objection of the revenue authorities that this issue was not originally raised in the first round of proceedings, we agree with the contention of the ld. AR that the entire issue of comparability of the companies was set aside to the TPO and it was open for the assessee to seek inclusion of this company based on a fresh TP study. We hold this issue in favour of the assessee.
The next issue in ground No.6 raised by the assessee is relating to exclusion of working capital adjustment while computing the ALP. We notice that the this Tribunal in assessee’s own case (supra), has decided this issue in favour of the assessee with the following observations:-
“26. In the case of Nagravision India (P.) Ltd., (supra), the Tribunal held that the working capital adjustment should be allowed. For holding so, the Tribunal has followed the decision rendered by another Bench in the case of Huawei Technologies (India) (P.) Ltd. v. Jt. CIT [2019] 101 taxmann.com 313 (Bang. -
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Trib.). The decision rendered in the case of Huawei Technologies (India) (P.) Ltd. (supra) are extracted below:— '10. The next grievance projected by the Assessee in its appeal is with regard to the action of the CIT (A) in not allowing any adjustment towards working capital differences. On this issue we have heard the rival submissions. The relevant provisions of the Act in so far as comparability of international transaction with a transaction of similar nature entered into between unrelated parties, provides as follows: Determination of arm's length price under section 92C. 10B. (1) For the purposes of sub-section (2) of section 92C, the arm's length price in relation to an international transaction [or a specified domestic transaction] shall be determined by any of the following methods, being the most appropriate method, in the following manner, namely ;— (a) to (b)** ** ** (e) transactional net margin method, by which,— (i) the net profit margin realised by the enterprise from an international transaction [or a specified domestic 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 [or the specified domestic 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;
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(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 [or the specified domestic transaction); (f)** ** ** (2) For the purposes of sub-rule (1), the comparability of an international transaction [or a specified domestic transaction] with an uncontrolled transaction shall be judged with reference to the following, namely:— (a) the specific characteristics of the property transferred or services provided in either transaction; (b) the functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to the transactions; (c) the contractual terms (whether or not such terms are formal or in writing) of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions; (d) conditions prevailing in the markets in which the respective parties to the transactions operate, including the geographical location and size of the markets, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition and whether the markets are wholesale or retail. (3) An uncontrolled transaction shall be comparable to an international transaction [or a specified domestic transaction] if— (i) none of the differences, if any, between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from, such transactions in the open market; or IT(TP)A No.1839/Bang/2019 Page 20 of 28 (ii) reasonably accurate adjustments can be made to eliminate the material effects of such differences.
A reading of Rule 10B(l)(e)(iii) of the Rules read with Sec. 92CA of the Act, would clearly shows that the net profit margin arising in comparable uncontrolled transactions has to be adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, which could materially affect the amount of net profit margin in the open market.
Chapters I and III of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (hereafter the "TPG") contain extensive guidance on comparability analyses for transfer pricing purposes. Guidance on comparability adjustments is found in paragraphs 3.47-3.54 and in the Annex to Chapter III of the TPG. A revised version of this guidance was approved by the Council of the OECD on 22 July 2010. In paragraph 2 of these guidelines it has been explained as to what is comparability adjustment. The guideline explains that when applying the arm's length principle, the conditions of a controlled transaction (i.e. a transaction between a taxpayer and an associated enterprise) are generally compared to the conditions of comparable uncontrolled transactions. In this context, to be comparable means that: ♦ None of the differences (if any) between the situations being compared could materially affect the condition being examined in the methodology (e.g. price or margin), or ♦ Reasonably accurate adjustments can be made to eliminate the effect of any such differences. These are called "comparability adjustments.
13. In Paragraphs 13 to 16 of the aforesaid OECD guidelines, need for working capital adjustment has been explained as follows: "13. In a competitive environment, money has a time value. If a company provided, say, 60 days trade terms for payment of accounts, the price of the goods should equate
IT(TP)A No.1839/Bang/2019 Page 21 of 28 to the price for immediate payment plus 60 days of interest on the immediate payment price. By carrying high accounts receivable a company is allowing its customers a relatively long period to pay their accounts. It would need to borrow money to fund the credit terms and/or suffer a reduction in the amount of cash surplus which it would otherwise have available to invest. In a competitive environment, the price should therefore include an element to reflect these payment terms and compensate for the timing effect.
14. The opposite applies to higher levels of accounts payable. By carrying high accounts payable, a company is benefitting from a relatively long period to pay its suppliers. It would need to borrow less money to fund its purchases and/or benefit from an increase in the amount of cash surplus available to invest. In a competitive environment, the cost of goods sold should include an element to reflect these payment terms and compensate for the timing effect.
A company with high levels of inventory would similarly need to either borrow to fund the purchase, or reduce the amount of cash surplus which it is able to invest. Note that the interest rate July 2010 Page 6 might be affected by the funding structure (e.g. where the purchase of inventory is partly funded by equity) or by the risk associated with holding specific types of inventory) 16. Making a working capital adjustment is an attempt to adjust for the differences in time value of money between the tested party and potential comparables, with an assumption that the difference should be reflected in profits. The underlying reasoning is that: ♦ A company will need funding to cover the time gap between the time it invests money (i.e. pays money to supplier) and the time it collects the investment (i.e. collects money from customers) ♦ This time gap is calculated as: the period needed to sell inventories to customers + (plus) the period needed to collect money from customers - (less) the period granted to pay debts to suppliers."
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Examples of how to work out adjustment on account of working capital adjustment is also given in the said guidelines. The guideline also expresses the difficulty in making working capital adjustment by concluding that the following factors have to be kept in mind (i) The point in time at which the Receivables, Inventory and Payables should be compared between the tested party and the comparables, whether it should be the figures of receivables, inventory and payable at the year end or beginning of the year or average of these figures, (ii) the selection of the appropriate interest rate (or rates) to use. The rate (or rates) should generally be determined by reference to the rate(s) of interest applicable to a commercial enterprise operating in the same market as the tested party. The guidelines conclude by observing that the purpose of working capital adjustments is to improve the reliability of the comparables.
15. In the present case the TPO allowed working capital adjustment accepting the calculation given by the Assessee. The CIT (A) in exercise of his powers of enhancement held that no adjustment should be made to the profit margins on account of working capital differences between the tested party and the comparable companies for the following reasons: (i) The daily working capital levels of the tested party and the comparables was the only reliable basis of determining adjustment to be made on account of working capital because that would be on the basis of working capital deployed throughout the year. (ii) Segmental working capital is not disclosed in the annual reports of companies engaged in different segments and therefore proper comparison cannot be made. (iii) Disclose in the balance sheet does not contain break up of trade and non-trade debtors and creditors and therefore working capital adjustment done without such break up would result in computation being skewed. (iv) Cost of capital would be different for different companies and therefore working capital adjustment made disregarding this different based on broad
IT(TP)A No.1839/Bang/2019 Page 23 of 28 approximations, estimations and assumptions may not lead to reliable results.
16. The CIT (A) also placed reliance on a decision of Chennai ITAT in the case of Mobis India Ltd. v. Dy. CIT [2013] 38 taxmann.com 231/[2014] 61 SOT 40. That decision was based on the factual aspect that the Assessee was not able to demonstrate how working capital adjustment was arrived at by the Assessee. Therefore nothing turns on the decision relied upon by the CIT (A) in the impugned order. In the matter of determination of Arm's Length Price, it cannot be said that the burden is on the Assessee or the Department to show what is the Arm's Length Price. The data available with the Assessee and the Department would be the starting point and depending on the facts and circumstances of a case further details can be called for. As far as the Assessee is concerned, the facts and figures with regard to his business has to be furnished. Regarding comparable companies, one has to fall back upon only on the information available in the public domain. If that information is insufficient, it is beyond the power of the Assessee to produce the correct information about the comparable companies. The Revenue has on the other hand powers to compel production of the required details from the comparable companies. If that power is not exercised to find out the truth then it is no defence to say that the Assessee has not furnished the required details and on that score deny adjustment on account of working capital differences. Regarding applying the daily balances of inventory, receivables and payables for computing working capital adjustment, the Delhi Bench of ITAT in the case of ITO v. E Value Serve.com [2016] 75 taxmann.com 195 (Delhi - Trib.). has held that insisting on daily balances of working capital requirements to compute working capital adjustment is not proper as it will be impossible to carry out such exercise and that working capital adjustment has to be based on the opening and closing working capital deployed. The Bench has also observed that that in Transfer Pricing Analysis there is always an element of estimation because it is not an exact science. One has to see that reasonable adjustment is being made so as to bring both comparable and test party on same footing. Therefore there is little merit in CIT (A)'s objection on working adjustment based on unavailable daily working
IT(TP)A No.1839/Bang/2019 Page 24 of 28 capital requirements data. There is also no merit in the objection of the CIT (A) regarding absence of segmental details available of working capital requirements of comparable companies chosen and absence of details of trade and non-trade debtors of comparable companies as these details are beyond the power of the Assessee to obtain, unless these details are available in public domain. Regarding absence of cost of working capital funds, the OECD guidelines clearly advocates adopting rate(s) of interest applicable to a commercial enterprise operating in the same market as the tested party. Therefore this objection of the CIT (A) is also not sustainable.
17. In the light of the above discussion we are of the view that the CIT (A) was not justified in denying adjustment on account of working capital adjustment. Since, the CIT (A) has not found any error in the TPO's working of working capital adjustment, the working capital adjustment as worked out by the TPO has to be allowed. We may also add that the complete working capital adjustment working has been given by the Assessee and a copy of the same is at pages 173 & 192 of the Assessee's paper book. No defect whatsoever has been pointed out in these working by the CIT (A). We may also further add that in terms of rule 10B(1)(e) (iii) of the Rules, the net profit margin arising in comparable uncontrolled transactions should be adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions which could materially affect the amount of net profit margin in the open market. It is not the case of the CIT (A) that differences in working capital requirements of the international transaction and the uncontrolled comparable transactions is not a difference which will materially affect the amount of net profit margin in the open market. If for reasons given by CIT (A) working capital adjustment cannot be allowed to the profit margins, then the comparable uncontrolled transactions chosen for the purpose of comparison will have to be treated as not comparable in terms of rule 10B(3) of the Rules, which provides as follows: "(3) An uncontrolled transaction shall be comparable to an international transaction if-
IT(TP)A No.1839/Bang/2019 Page 25 of 28 (i) none of the differences, if any, between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or cost charged to paid in, or the profit arising from, such transactions in the open market; or (ii) reasonably accurate adjustments can be made to eliminate the material effects of such differences."
In such a scenario there would remain no comparable uncontrolled transactions for the purpose of comparison. The transfer pricing exercise would therefore fail. Therefore in keeping with the OECD guidelines, endeavor should be made to bring in comparable companies for the purpose of broad comparison. Therefore the working capital adjustment as claimed by the Assessee should be allowed. We hold and direct accordingly.' 27. Respectfully following the judicial pronouncement above we hold that the AO is not justified in denying the working capital adjustment to the assessee. We accordingly direct the AO to allow the working capital adjustment. The assessee appeal on this ground is allowed.”
Following the above decision of this Tribunal, we direct the AO to allow the working capital adjustment to the assessee. This ground of the assessee is allowed.
The next ground pertains to the adjustment to the interest on External Commercial Borrowings (ECB). The assessee has taken ECB from its AE at an interest rate of LIBOR + 1.5%. In the original proceedings, the assessee submitted before the TPO that RBI has mentioned the highest cap on the spread above the LIBOR and the banks in India charge interest on ECB not less than LIBOR + 1.5%. Therefore, the interest charged by the assessee is within arm’s length.
IT(TP)A No.1839/Bang/2019 Page 26 of 28 The TPO rejected this claim stating that RBI is the agency only to deal with foreign exchange management and not arm’s length nature of interest charged on loans. He relied on the decision of Coca Cola India Inc. v. ACIT (2008 TIOL 658 HC P&H-IT) in this regard. The TPO proceeded to adopt CUP rate and computed the interest @ 4.92% i.e., average of 6 months EURO LIBOR for 2006-07 at 3.54% + 138 basis points resulting in a TP adjustment of Rs.1,32,114. In the remand proceedings, the TPO made the same addition stating that the assessee has not demonstrated anything new. The DRP upheld the order of the TPO.
Before us, the ld. AR submitted that the assessee has borrowed loans from its AE upon terms and conditions in accordance with the Guidelines of the Master Circular issued by the RBI. The RBI Circular at that point of time permitted the ECB to have an interest rate of LIBOR Plus 3%. It is submitted that this rate may be treated as being at Arm's Length. The ld. AR relies on the decision of the Bangalore ITAT in the case of Tuppadahalli Energy India Pvt. Ltd. v DCIT [IT(TP)A No. 2207/Bang/2016] and Hon'ble Karnataka High Court in the case of DDIT v GE India Technology Centre Pvt Ltd [ITA No 282 of 2013].
The ld. DR, on the other hand submitted that the DRP stated that the TPO computed arm's length interest under CUP method. Under CUP the interest that is charged between unrelated parties under similar circumstances would be taken as arm's length interest. The issue that is examined was the interest rate at which tax payer would
IT(TP)A No.1839/Bang/2019 Page 27 of 28 have got the loan from unrelated third parties. It is verified by the TPO that no security is provided by the assessee against the loans received. In the circumstances, the DRP upheld the method adopted by the TPO to arrive at the arm's length interest. Accordingly, it is held that RBI rates do not apply to the transactions under consideration. He submitted that the order of the DRP may be upheld.
We have considered the rival submissions and perused the material on record. During the course of hearing, the ld. AR drew our attention to the Master Circular of RBI, RBI/2005-06/87, A.P.(DIR Series) Circular No.5 dated 1.8.2005 which is at pages 99 to 103 of PB, wherein sub-clause (IV) of clause (A) of the Annexure to the Circular provides as follows:-
“The all-in-cost ceilings for ECB are indicated from time to time. The following ceilings are valid till reviewed. Average Maturity Period All-in-cost Ceilings over 6 month LIBOR* Three years and up to five 200 basis points years More than five years 350 basis points * for the respective currency of borrowing or applicable benchmark.
We see merit in the argument of the ld AR that the assessee’s borrowing is for one year period as per the terms of the loan agreement (pg. 98 of PB) and therefore LIBOR + 150 basis points is justified to be at arm’s length. In view of this we hold that the interest charged by IT(TP)A No.1839/Bang/2019 Page 28 of 28 the assessee at LIBOR + 150 basis points which is within the range as per the RBI’s Master Circular, is within the arm’s length. The adjustment made on this count is hereby deleted. This ground is held in favour of the assessee.
The TPO is directed to recalculate the ALP as per directions contained in this order.
In the result, the appeal by the assessee is partly allowed.
Pronounced in the open court on this 27th day of June, 2022..