ASSISTANT COMMISSIONER OF INCOME-TAX vs. M/S. HYUNDAI CONSTRUCTION EQUIPMENT INDIA PVT. LTD.,, PUNE

आयकर अपीलीय अिधकरण, पुणे �यायपीठ “ए” पुणे म� IN THE INCOME TAX APPELLATE TRIBUNAL PUNE BENCH “A”, PUNE सु�ी सुषमा चावला, �याियक सद�य एवं �ी डी. क�णाकरा राव, लेखा सद�य के सम� BEFORE MS. SUSHMA CHOWLA, JM AND SHRI D. KARUNAKARA RAO, AM आयकर अपील सं. / ITA No.1472/PUN/2015 िनधा�रण वष� / Assessment Year : 2009-10 M/s. Hyundai Construction Equipment India Pvt. Ltd., Plot No.A/2, Chakan MIDC, Phase-II, Khalumbre, Chakan – Talegaon Road, Chakan, Tal. Khed, Pune-410501. अपीलाथ�/Appellant PAN : AABCH8756Q …. Vs. DCIT, Circle-9, …. ��यथ� / Respondent Pune. आयकर अपील सं. / ITA No.1670/PUN/2015 िनधा�रण वष� / Assessment Year : 2009-10 ACIT, Circle-9, अपीलाथ�/Appellant Pune. …. Vs. M/s. Hyundai Construction Equipment India Pvt. Ltd., Plot No.A/2, Chakan MIDC, Phase-II, Khalumbre, Chakan – Talegaon Road, Chakan, Tal. Khed, Pune-410501. …. ��यथ� / Respondent PAN : AABCH8756Q अपीलाथ� क� ओर से / Appellant by : Shri M. P. Lohia ��थ� की ओर से / Respondent by : Shri S. B. Prasad, CIT सुनवाई क� तारीख / घोषणा क� तारीख / Date of Hearing : 20.02.2019 Date of Pronouncement: 19.03.2019 आदेश / ORDER PER D. KARUNAKARA RAO, AM : These are the cross appeals filed by the assessee as well as by the Revenue against the order of the CIT(A)-13, Pune dated 31.08.2015 for the assessment year 2009-10.

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ITA No.1472/PUN/2015 (By Assessee) 2. Before us, at the outset, ld. Counsel for the assessee brought our attention to the grounds of appeal of the assessee and submitted that the ground nos.1, 3, 4 and 6 being general or academic have to be dismissed as not pressed. Accordingly, they are dismissed as such. 3. The rest of the ground nos.2 and 5, which are left for adjudication, are extracted as follows :- Inappropriately selecting an additional company BEML Limited as “2. comparable to the Appellant for FY 2008-09 and incorrect computation of operating profit margins of BEML Limited for FY 2008-09. Erred on the facts and in circumstances of the case by inappropriately considering an additional company, BEML Limited as comparable to the Appellant for FY 2008-09. Without prejudice to the above, erred by incorrectly computing operating profit margins of BEML Limited for FY 2008-09. Inappropriate non-consideration of the segmental financials 5. providing split between trading and manufacturing operations of the Appellant and concluding that trading operations should at least break even. Erred on the facts and in circumstances of the case and in law by inappropriately rejecting segmental financials providing split between trading and manufacturing operations of the Appellant and concluding that trading operations of the Appellant should at least break even and thereby arbitrarily shifting expenses amounting to Rs.10 crores from trading operations to manufacturing operations.” During the proceedings before us, assessee also filed an additional 4. ground and the same reads as under :- “Ground of appeal 7 – Inappropriate computation of transfer pricing adjustment on the total operating revenue from manufacturing operations of the Appellant instead of only to the value of international transactions. The ld. AO erred in not following the directions of Hon’ble CIT(A), in computing the proportionate transfer pricing adjustment i.e. adjustment if any, only in respect of value of international transactions instead on total operating revenue.” 5. Referring to the additional ground, ld. Counsel submitted that the said additional ground relates to the transfer pricing adjustment to the international transactions only and not to the entire turnover at the entity

3 ITA No.1472/PUN/2015 ITA No.1670/PUN/2015 level. Further, Ld. AR submitted that the said additional ground stands now covered in favour of the assessee by series of judgements/decisions. Considering the legal nature of the issue, the said additional ground is admitted for adjudication. 6. Now, we shall take up ground-wise adjudication of the appeal of the assessee. The relevant facts of the case are that the assessee is a company engaged in the business of manufacturing and trading of excavators. The assessee company is also engaged in trading of spares of these vehicles. The assessee filed the return of income declaring total loss of Rs.64,81,22,005/-. The Transfer Pricing Officer (TPO) passed order u/s 92CA(3) of the Act on 04.04.2013 wherein an adjustment of Rs.26,16,65,000/- was quantified in respect of the international transactions with Associated Enterprises (AEs) in the manufacturing segment. No adjustments were recommended in the trading division of the assessee. Accordingly, order u/s 143(3) r.w.s. 144C(13) of the Act was passed by the Assessing Officer on 04.04.2013 after determining the total loss of the assessee at Rs.38,64,57,005/- as against the returned total loss of Rs.64,81,22,005/-. Aggrieved by the order passed u/s 143(3) r.w.s. 144C(13) of the Act dated 04.04.2013, the assessee filed the appeal before the CIT(A). 7. The facts relating to the issues on hand are that the assessee has two segments, i.e. (i) manufacturing segment and (ii) trading segment. In benchmarking the international transactions of manufacturing division, the assessee restricted in its TP study to two of the comparables i.e. JCB India and Telco Equipment. However, during the TP proceedings, the TPO included Bharat Earth Movers Ltd. (BEML) which was earlier considered

4 ITA No.1472/PUN/2015 ITA No.1670/PUN/2015 and rejected by the assessee during its TP study. Reasons for rejection by the assessee include that the functions of BEML are not comparable as the same is engaged in the manufacturing of wide range of products. Further, the data relating to the mining and construction business of BEML are not available. Further, the assessee submitted that the filter of having 75% of total revenue from comparable activities is not satisfied in case of BEML. As per the assessee, (i) JCB India with 11.92% of OP/Income; and (ii) Telco Equipment with 8.32% of OP/Income are the only good comparables. During the TP proceedings u/s 92CA(3) of the Act, the TPO included BEML as a good comparable and rejected the objections of the assessee. Thus, the OP/Income of the 3 comparables rose to 16.41%. Aggrieved with the above inclusion of BEML, the assessee filed an appeal before the CIT(A) for exclusion of the said BEML from the list of good comparables. The CIT(A) considered the arguments of the assessee and confirmed the view taken by the Assessing Officer. The contents of paras 2.2.1 to 2.2.11 are relevant in this regard. 8. The CIT(A) extracted the written submissions of the assessee in para 2.2.2 of his order. As per the assessee, the BEML has various division such as (i) Mining and construction business; (ii) Defence business; (iii) Rail & Metro business; (iv) Trading division; and, (v) Technology division. In the TP study, the assessee analyzed the details of the products of BEML and held the same are not comparable to the products manufacturing by the assessee under consideration. Further, relying on the shareholding details on BEML, the assessee submitted that BEML, with 54% shareholding of the Government of India, constitutes a Government company. Therefore, the profits of BEML are not comparable as it has fixed customers unlike the assessee who operates in the competitive environment. In this regard, the

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assessee relied on the decision of Mumbai Bench of the Tribunal in the case of Chemtex Global Engineers P. Ltd. vs. DOI (ITA No.3590/Mum/2010), decision of Delhi Bench of the Tribunal in the case of Honda Trading Corporation India Pvt. Ltd. (ITA No.4811/Del/2012) and decision of Mumbai Bench of the Tribunal in the case of Thyssenkrupp Industries India (P.) Ltd. vs. ACIT (ITA No.6460/Mum/2012) for the proposition that the Government company are required to be excluded from the list of comparables. Thus, the assessee’s contentions revolve around the twin arguments i.e. (i) on account of function test and (ii) on account of Government shareholding in the company. As per the assessee, the BEML is not a good comparable. 9. On considering the above arguments of the assessee, the CIT(A) examined each of these decisions cited by the assessee in para 2.2.4 to 2.2.8 and held the following (para 2.2.9 to 2.2.11) :- “2.2.9 None of the above decisions are applicable to the facts of the case. It may be mentioned that BEML is strictly not a government company. The government is a major shareholder but it is a listed company on the stock exchange in which, 46% of its stakes is held by financial institutions, foreign financial institutions and private share holders. BEML for all practical purposes functions like a private sector company and because of its good commercial track record, it is known to be one of the ‘navaratna’ of the Government of India. In such factual background, it would be improper to exclude BEML on the ground of it being a government company. 2.2.10 Further, the jurisdictional tribunal, in the case of Vishay Components Pvt. Ltd. vs. DCIT ITA No.133/PN/11 AY 2006-07 dated 05.02.2012 has held that the company cannot be excluded merely because it is a government company. Para 24 the honourable ITAT held that ‘in our considered opinion, mere fact that Comparable Company is owned by Government, it cannot be a criteria to reject the same, inasmuch as ownership structure of a concern is normally not expected to have a bearing on its operating margins’. 2.2.11 In view of the above discussion, I hold that learned TPO was correct in accepting ‘mining and construction segment’ of the BEML as comparable with the Appellant. I confirm the action of the learned TPO in this regard.” 10. Aggrieved with the above decision of the CIT(A), the assessee is in appeal before the Tribunal with the above extracted ground no.2.

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suppliers are different. Their profit margins are different. They would not operate in a free competitive environment. Therefore, in our opinion, the orders of the lower authorities need to be reversed. The Co-ordinate Bench of the Tribunal has already taken a view in the matter. Considering the above reasoning as well as the Coordinate Bench decision (supra), we are of the opinion the Government company like BEML cannot be held as a good comparable to the one like the present assessee – a private company under consideration. Regarding the ld. DR’s argument about the existence of profit making company in the client list of BEML, we find it is not a sustainable argument. 14.1 Further, we find Hon’ble Bombay High Court has given a categorical finding about the requirement of excluding Government companies like M/s. Engineers India Limited held in the case of M/s. Thyssen Krupp Industries India Pvt. Ltd. (239 Taxman 46 (Bom.), is relevant and binding on us. For the sake of completeness, conclusion part of the judgment is extracted as under :- “Where a substantial part of revenue of a comparable Co. in execution of turnkey projects arose out of executing projects of public sector undertakings, it could not be considered to be comparable to assessee-company providing turnkey services to its AE as contracts between Public Sector undertakings were not driven by profit motive alone but other consideration also weigh in such as discharge of social obligations etc.” 15. Therefore, the decisions of the CIT(A), Assessing Officer and the TPO are required to be reversed. Considering the relief granted to the assessee, we find it relevant to not go into the other arguments relating to the functional test of BEML and other arguments raised by the assessee’s AR. Accordingly, ground no.2 is allowed without going into the merits of the function test. Thus, ground no.2 is allowed.

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Accordingly, TPO/Assessing Officer questioned the basis of allocation of expenses and quantified the excessiveness. Assessing Officer determined the said excessiveness at Rs.10 crores on ad-hoc basis. Rs.10 crores is booked to the manufacturing account thereby reducing the OP/Income of the manufacturing segment. Before the CIT(A), this issue was adjudicated in para 2.5.4 of his order. The CIT(A) analyzed the profitability statements of manufacturing and trading operations of the assessee in the said paragraph (para 2.5.4) before confirming the decision of the TPO/Assessing Officer. Otherwise, the assessee followed sales ratio in matters of adjudicating expenditure between the two segments. The relevant paras 2.5.5 to 2.5.10 of the order of the CIT(A) are extracted hereunder :- “2.5.5 I find that the Appellant has allocated majority of the expenses other than the cost of goods sold in the ratio of turnover between manufacturing and trading. It is fundamental accounting principle that if any expenditure is incurred for the particular segment, it would constitute direct expenditure for such segment. It is only common un-allocable expenses are allocated on the basis of the some allocation key. However, to allocate almost entire expenses below the line in proportion to turnover as the Appellant has done in this case, is unheard of and is against the accountancy principles and business reality. Therefore, such allocation is not possible to accept. 2.5.6 For example, the Appellant’s allocation of employee cost is not transparent and gives impression that major part of total employee cost of Rs.10 cr. Is allocated on the basis of sales ratio. It may be mentioned that the segmental accounts are furnished by many companies in their Annual Reports. However, it is a matter of common knowledge that un-allocable expenses constitute minor percentage of the total expenses, which are not directly allocated. However, in this case, the situation is exactly reverse. This makes the segmental accounts prepared by the Appellant unreliable. 2.5.7 Secondly, the Appellant is in start-up phase. Turnover of its manufacturing and trading function is almost similar. However, it is a matter of common sense that the Appellant would incur much more expenses in its manufacturing function because it is in the start-up phase and would incur lesser expenses in trading function. Trading function is not affected by the problems of the start-up phase. Yet, the Appellant has debited more interest expenses towards trading function than manufacturing functions whereas, the apportionment of all ‘other expenses’ between the manufacturing and trading functions are similar. As stated, employee cost is almost equal of Rs.5 cr. Each in both the segments. This pattern is impossible to accept. 2.5.8 The above aspect also can be explained from other perspective. According to the Appellant’s Transfer Pricing Study Report, the Appellant has performed many more functions and assumed more risks in manufacturing functions than in trading functions. It is a matter of common sense there are more functions and risks in manufacturing activity than in trading activity. Consequently, the enterprise would incur more expenses to perform more functions and to meet greater risks in manufacturing activity. Therefore, if the turnover of manufacturing and trading is similar, then the expenses incurred in manufacturing activity ought to be very high as compared to the

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trading function. However, the Appellant’s has allocated almost same expenses to manufacturing and trading function. 2.5.9 Thirdly, the Appellant has suffered loss in trading activity. This itself is improbable event in trading. In trading, unless there is distress sale or if certain events have taken place beyond control normally, there is no loss in trading function as it functions on ‘cost plus’ basis in such products. The Appellant has not explained the reasons for incurring of losses by it in trading activity in para 5.5 of its transfer pricing study report. The Appellant has stated that it has suffered loss for business reasons however, no mention of it in its transfer pricing study report make the segmental accounts with loss in trading function unreliable. 2.5.10 In view of the above, it is not possible to accept split-financials prepared by the Appellant. I confirm the decision of the learned TPO to reject split-financials prepared by the Appellant.” 19. Thus, the TPO/Assessing Officer shifted the expenditure of Rs.10 crores to the manufacturing division from the trading segment on ad-hoc basis. 20. Aggrieved with the above decision of the CIT(A), the assessee raised the said ground no.5 before us. 21. Before us, ld. Counsel for the assessee submitted that the assessee is a start-up company, operated for few month in the year under consideration and the capacity utilization is only 4.5%. Further, the ld. Counsel for the assessee took objection to the adverse finding of the Assessing Officer/TPO, who questioned the certificate issued by Chartered Account in matter of expenditure allocation. Justifying the said certificate, ld. AR submitted that the assessee adopted sales-based allocation. Justifying the said criteria of sales ratio, ld. Counsel brought our attention to the contents of para 12 at page 362 of the Paper Book and submitted that the said criterion is well accepted one now. He also referred to page 75 of the appeal papers and submitted that the TPO himself accepted the said criteria as a reliable one. The ld. Counsel submitted that the criteria of ‘ad- hocism’ in matters of shifting Rs.10 crores of expenditure out of the trading

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account to transferring the same to the manufacturing account without studying each and every account debited to the Profit and Loss Account, is not sustainable in law. Assessing Officer should analyze the criteria adopted thereon i.e. sales linked allocation. The ld. AR also found mistake in the Assessing Officer’s order, who held that no loss is possible in the trading account. Referring to page 279 and 280 of the Paper Book, ld. Counsel brought our attention to the Assessing Officer’s directions. 22. On the other hand, ld. DR for the Revenue submitted that the assessee failed to submit account-wise criteria and its ranges to the sales ratio. Therefore, Ld. DR justified the ad-hoc approach adopted by the Assessing Officer/TPO in the assessment order. However, Ld. DR argued to the fact that no account-wise specific allocation was done in this case before ad-hocism was resorted. 23. We have heard both the sides on this issue of shifting of Rs.10 crores out of the trading expenditure to the manufacturing account thereby altering the profit-ratio of the manufacture segment. We also noted that none of the officials below i.e. Assessing Officer/TPO and CIT(A), have not undertaken the data analysis relating to the nexus of each of the expenditure before applying the sales ratio as a bona-fide basis for allocation of expenses. On hearing both the sides, we find the decisions cited by the ld. Counsel are exactly not applicable to the facts of the present case. There is requirement for the Assessing Officer/CIT(A) to undertake the scrutiny of each of the expenditure accounts and analyze the nexus of the expenditure to the trading and manufacture segments on one side and the application of proper and appropriate basis to allocate the expenditure

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between the segments. Assessing Officer should also pass a speaking order why the stated sales ratio is inappropriate on given facts. 24. Therefore, we are of the opinion, this issue is required to be remanded to the file of the Assessing Officer/TPO with regard to the approved the applicability of the basis of sales ratio uniformly to all the accounts qua the trading and manufacturing account. With these directions, we remand this issue to the file of the Assessing Officer/TPO for fresh examination of the issue. The Assessing Officer shall grant a reasonable opportunity of being heard to the assessee in accordance with set principles of natural justice. Accordingly, relevant ground no.5 is allowed for statistical purposes. Additional Ground: Before us, the assessee raised an additional 25. ground (extracted above) stating that the adjustments were made identity level instead of international transaction only. The CIT(A) decided the issue by observing as under :- “2.6.3 I have considered the arguments of the Appellant. I find that the learned TPO has changed the transfer pricing method to TNMM from what was used by the Appellant (TNMM and RPM) therefore; onus is on the learned TPO to make the adjustment on the value of the international transaction as required u/s 92 of the Income Tax Act. It is clear that the adjustment can be made only to the value of the international transaction. Under TNMM, in absence of the determination of the net margin on value of the international transaction by the learned TPO, it will be presumed that the net margin of the international transaction will be the same as that of the average net margin of the comparable companies. Accordingly, I direct the learned AO to make the adjustment to the value of the international transaction.” 26. The issue of restricting the adjustments to the extent of international transactions with AEs only, has been considered by us. We have also considered the legal proposition in existence on this issue and find it is settled legal matter that the adjustments cannot be extended to the entire receipts/turnover of the entity which may include transactions with non-

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AEs. TP adjustments need to be restricted to transaction with AEs only. In this regard, the Jurisdictional High Court judgement in the case of CIT vs. Firestone International (P.) Ltd. (378 ITR 558) is relevant and the same is binding on us. The said decision is relevant for the conclusion of the ratio that the ALP can be considered on value of international transaction alone and not entire turnover of the assessee. In this case, the Revenue was aggrieved against the order of the Tribunal and the same was agitated before the Hon’ble High Court vide Question of Law 2(a) of the appeal and in para 3 of the said question of law was not entertained as substantial question of law. For the sake of completeness, the said para 3 is extracted hereunder :- “3. As far as Question (a) is concerned, the learned Counsel for the Revenue is unable to show how it arises from the impugned order of the Tribunal. It appears that the question itself is academic. In the above view, there is no occasion to entertain Question (a) as substantial question of law.” 27. The said judgement of the Hon’ble High Court has become final by virtue of the Hon’ble Supreme Court judgment in the same case vide SLP(C)CC No.22512/2015 dated 05.01.2016. In fact, the Co-ordinate Bench of the Tribunal has also taken similar view in the case of Demag Cranes & Components (India) Pvt. Ltd. vs. DCIT vide ITA No.120/PN/2011 order dated 04.01.2012. The issue of manner of computation of adjustments restricting to the international transactions with AEs was discussed at length in paras 45 to 49 in the said order of the Tribunal (supra). For the sake of completeness, the said paras 45 to 49 are extracted as follows :- “45. Ground 10 refers to incorrect computation of TP adjustments to the manufacturing activity. In this regard, referring to the manufacturing segment and sale affected in this segment, Sri Lohia read out that the total sale of this segment is Rs 23,32,42,565/- and the relatable cost of material is Rs 1528.65 lakhs, (of course, the assessee submitted a different figure of Rs 1557.39 lakhs in some other context). Thus, this cost of material (controlled and uncontrolled cost) of Rs 1557.39 lakhs includes the Rs 602.19 lakhs, relatable to the transactions with AEs ie controlled cost. As per the Counsel,

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revenue has erred in computing the TP adjustment on the entire manufacturing segment sales instead of computing the TP adjustment on those sales relatable to the import of the components and spares procured from the AEs only. While establishing the ALP on this segment, the AO worked out the said variance @ 4.77% (i.e. 7.18% - 2.41%) and worked out the corresponding quantum of adjustment at Rs 1,11,25,670/- (i.e. 4.77*23,32,42,565/100). In this regard, the Ld counsel for the assessee mentioned that if total international transactions under consideration for adjustment on account of ‘Import of raw materials, components and spares for assembly/manufacture of material handling products’ worth Rs 60,218,878/- works out to only 40% of the total cost, the same proportion of the total sales has to be considered for making TP adjustments. If the assessee’s manner of adjustment is considered the additions should be restricted to Rs 43,82,783/- only (Rs 11,125,670 * Rs 60,218,878/Rs 152,865,285). In this regard, Ld Counsel relied on the provisions of the Rule 10B(1)(e) and also various judicial pronouncements on the subject ie (i) Emerson process Management India P Ltd ITA NO 8118/m/2010; (II) T Two International P Ltd and others; IL Jin electronics I PLtd 36 SOT 227 Del; Starlite case 2010-TII-28-ITAT-DEL-TP; Abhishek Auto Industries Ltd 2010- TII-54-ITAT-DEL-TP etc. 46. We have heard the parties and perused the relevant provisions of the said rule. Sub clause (i) and (ii) of the Rule 10B(1)(e) referred to the expressions ‘in relation to’ and the ‘relevant base’. They read as follows: (i) The net profit margin realized 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 realized 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; 47. From the above, it is vivid that in TNMM, the net profit margin realized by the tested party, an assessee, out of the international transaction is computed in relation to sale effected (as in assessee’ case), which is the relevant base. The expression ‘in relation to’ means ‘in connection with’ and it implies connection between impugned international transactions worth Rs 60,218,878/- on account of Import of raw materials, components and spares for assembly/manufacture of material handling products’ and to the related sales and not to the entire sales of the manufacturing segment of the assessee. The said relationship/ratio is the requirement in the present comparability analysis and not the entity level sales as wrongly considered by the TPO and relied upon by the DRP. In principle, such closure comparability analysis is needed in TNMM, when sales is used as a base for determining net profit margin. Thus, it is erroneous to bring relationship between the Rs 60,218,878/- and Rs 23,32,42,565/- ie the total sales. Assessee’s failure to supply the data on relevant sales is no defense, when there are settled alternatives for adoption in such circumstances, well tested ‘principle of proportionality’ in our opinion should help. Thus, the base of sales does not need to be ‘total sales’; but the proportionate sales relatable to the impugned international transactions. It is a commonsensical approach. 48. In this regard, we have perused the existing decisions relied upon by the assessee and the following extracts from some of the decisions are relevant and the same read as follows. A. Emersons Process Management India P td – ITA NO 8118/M/2010 AY-2006-07 -Pg 452 of Paper Book “ 19. Fifthly, as has been consistently held by the coordinate benches, the transfer pricing adjustment is to be made with respect to international transaction and not the entries sales…………. We, therefore, direct the Assessing Officer to compute the transfer pricing adjustment in the light of this legal position. “

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B. T Two International P Ltd and Tara Jewels Eports P Ltd and Tara Ultimo P Ltd ITA NO 5644, 5645 & 5646/m/2008 Ay 2004-05 – para 13 @ page 460 of Paper Book “13. We have considered the rival submissions carefully. We partially agree with the submissions of the ld. Counsel for the assessee that original TPO’s order is definitely erroneous because he has applied the net profit margin of 7.25% on the gross sales and followed a complicated procedure to arrive at the amount of adjustment. In simple terms if the sales to Associated Enterprises is taken at Rs. 25 crores and straight way 7.25% margin is applied then approximately total margin would be Rs.1.81 crores, whereas adjustment has been made at Rs2,57,26,138/-...” C. IL Jin Electronics I P Ltd v ACIT 36 SOT 227 Page 470 of the Paper Book: “15. The assessee has also taken one alternative ground out of the total raw materials consumed by the assessee for manufacturing printing circuit boards, only 45.51 per cent of the total raw materials were imported through assessee’s associated concerns, and , therefore, any adjustment, if any called for, can only be made to the 45.51 per cent of the total turnover, and not to the total turnover of the assessee. After considering the facts of the case, we do not find any difficulty in accepting this contention of the assessee that at best only 45.51 per cent of the operating profit can be attributed to imported raw material acquired from assessee’s associate concerns. In the present case, the AO has calculated the operating profit on the entire sales of the assessee, which in our considered opinion, is not justified, when it is admitted position that only 45.51 per cent of raw material has been acquired by the assessee from its associate concerns for the purpose of manufacturing items.The assessee has stated that the operating profit if applied to 45.51 per cent of the turnover would come to Rs.35,52,573 as against operating profit of Rs.24,35,175 booked by the assessee, and the difference thereof would only be called for to be made as addition to the profit shown by the assessee. We, therefore, direct the AO to modify the assessment and make the adjustment only to the extent of difference in the arm’s length operating profit with adjusted profit with reference to the 45.51 per cent of the turnover, and not to the total turnover of the assessee. Therefore, to this extent, the addition made by the AO and further confirmed by the CIT(A) is reduced. We order accordingly.” D. DCIT vs Starlite 133 TTJ 425 Mum AY 2002-03 Page Para 13 at 478 of the Paper Book “13. As in this case, TPO has not applied TNMM, as contemplated in the Act, we have no other alternative but to set aside her order……….. We also agree with the arguments of learned counsel for the assessee that adjustments, if any, arising due to computation of ALP should be restricted only to the international transactions and not to the entire turnover of the assessee company. No addition can be made to local transactions under Chapter X of the Act. Such things are done only when the AO invokes s. 144. We direct the AO to restrict the adjustments, if any only to international transactions, which are found by him to have taken place at price other than ALP.“ E. Abhishek Auto Industries Ltd vs DCIT 136 TTJ 530 Del- para 8.2 at Page 494 of the Paper book: “8.2 It has not been disputed that provisions X, s. 92C deals with international transactions only and not with transactions which have no international cross-border element at all. Therefore, the basis of making the adjustments on the enterprise level by taking Rs.68.76 crores as the base is not correct. What should have been taken is the sale to domestic parties using Takata technoloty and Takata raw material amounting to Rs.12.74 crores. The segment that was to be

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looked at was the international segment, that is domestic sale using foreign technology and foreign raw material. As given by the appellant, the operating profit margin on AE sales is 10.49 per cent whereas in the domestic sales segment it is only 2.88 per cent. …………….. We, therefore, accept this second proposition also that only international transaction is to be taken into account while calculating the ALP”. 49. All these cited decision in general and the decision in the case of M/s IL Jin Electronics I P Ltd, supra , in particular are uniform in asserting that the TP adjustments are to computed not considering the entity level sales. Rather it should be done ideally considering the relatable sales drawing the quantitative relationship to the imports from the AEs, ie controlled cost. The principle of proportionality is relevant here and it is a settled law in this regard. In the situation like the one in the instant case of the assessee, there is data relating to controlled and uncontrolled cost particulars. This undisputed data is suffice to arrive the proportionate sales relatable to the international transaction with the AEs ie controlled cost. Accordingly, the grounds 10 relating to Incorrect computation of transfer pricing adjustment to the manufacturing activity is allowed pro tanto.” 28. Considering the above settled legal proposition on the issue, we are of the opinion that the said issue raised in the additional ground has to be decided in favour of the assessee. Consequently, we direct the Assessing Officer to restrict the adjustments, if any only to the international transaction with AEs. Accordingly, additional ground is adjudicated in favour of the assessee. Accordingly, the additional ground is allowed. 29. In the result, the appeal of the assessee is allowed. ITA No.1670/PUN/2015 (By Revenue) 30. The Revenue has raised the following grounds of appeal :- “1. Whether on the facts and circumstances of the case, the Ld. CIT(A) erred in directing the AO to make capacity adjustment by recommending a method without justifying the reliability of the method? 2. Whether on the facts and circumstances of the case, the Ld. CIT(A) erred in directing the AO to make adjustment to cost of assessee when income-tax rule 10B(e)(iii) prescribed that adjustment is to be made to comparable only? 3. Whether on the facts and circumstances of the case, the Ld. CIT(A) erred in directing the AO to compute the TP adjustment proportionate to international transactions entered by the assessee. The law does not provide for a pro-rata adjustment when TNMM is applied at segment level. 4. Whether on the facts and circumstances of the case, the Ld. CIT(A) was justified in giving relief out of total adjustment made by the TPO, without

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appreciating the non-availability of authentic bifurcation of the transactions between the AE and Non-AE? 5. The appellant craves leave to add, amend or alter any of the above ground of appeal.” 31. The ground nos.1 and 2 relates to the capacity adjustment to the cost. Further, ground nos.3 and 4 relate to the TP adjustment at the turnover level instead of restricting to the international transaction with AEs only. 32. Referring to Ground nos.1 and 2 (i.e. “capacity adjustment”), ld. Counsel for the assessee brought our attention to (i) the judgement of the Hon’ble Bombay High Court in the case of CIT vs. Petro Araldite (P.) Ltd. (256 Taxman 16) (copy of which is placed at page 436 of the Paper Book) as well as (ii) the contents of para 23 of the said decision of the Mumbai Bench of the Tribunal in the case of DCIT vs. Petro Araldite (P.) Ltd. in ITA No.3782/MUM/2012, order dated 24.07.2013 (copy of which is placed at page 440 to 454 of the Paper Book) and submitted that the formula provided in the said judgement is relevant. The detailed discussion mentioned by the CIT(A) in para 2.3.1 to 2.3.7 of his order are relevant. Further, the gist of the submissions extracted by the CIT(A) in para 2.3.1 is also relevant and hence, the said para (relevant portion) is extracted hereunder :- “2.3.1 The learned TPO computed the amount of the adjustment on account of the low capacity utilization as under :- It is submitted that the capacity utilization in case of assessee this year in respect of manufacturing activity is only 4.50%, it has accordingly made adjustments to the PLI of the comparables whose capacity utilization is higher. In the show cause notice the assessee was informed that any adjustment can be made as per IT Rules only if there are material differences that affect prices of transactions and reasonably accurate adjustments can be made to eliminate these differences. In the reply, the assessee has side stepped the question as to how low capacity utilization affects the price of the transactions. Assessee has merely stated that capacity utilization is different. Second, as regard the reported capacity utilization which is more than 100% in the case of comparable, leading to doubts on the reliability of installed capacity figure and the corresponding capacity utilization, the

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assessee in its reply has merely reiterated that the figures should be accepted as reliable and that this is the only information in public domain. The assessee in its TP report has claimed capacity utilization adjustments. The methodology adopted by the assessee comprises of fitting ‘a straight line through 3 data points on a two dimensional axis graph plotting Sales vs Total Costs for two comparables. The 3 data points is of sales and total costs for AY 2009-10 and two preceding years i.e. AY 2008-09 and 2007-08. This has been used by attempting to fit an equation y = a + bx. This mathematical model has been used to determine the average fixed costs across 3 years: The method adopted is not found acceptable for the following reasons. Firstly, this involves data for 3 years which is not sanctioned by the IT Rules which require contemporaneous data to be used. No case has been set up justifying the use of data of prior 2 years. Secondly, this assumes a mathematical model that relationship between sales and total costs is linear. There is no evidence or basis to support this hypothesis. In fact it is generally not the case that fixed costs will remain the same across years. In theory of finance and accounting too, no such theory is found. Thirdly, the statistical indicator of goodness of fit to validate the accuracy of model is not submitted despite specifically calling for the same. Fourthly, a visual inspection of the scatter diagram shows that there are three data points through which a straight line is drawn which does not fit well. In the case of JCB, the two data points almost overlap and thus a straight line is drawn virtually through two points only. Thus, the assumption is neither accurate nor based in any financial theory. In fact, there is no analysis of the nature of actual expenditure. Hence, the methodology adopted is rejected. 9.8 Without prejudice to the view that adjustment can be made to PLI of comparables only in respect of transactional difference of functions, assets and risks and not to specific items of expenditure which may be higher in the case of the tested entity, the approach adopted in this order is to determine the adjusted PLI for each comparable treating depreciation as fixed costs, and assuming that the comparable operated at the same level of capacity utilization as the assessee ie at 4.50%. The data of capacity utilization in the case of JCB India Ltd is not found to be reliable as mentioned in SCN. The data of capacity utilization is not available in, case of BEML. Hence, only, Telco Construction Equipment Co Ltd. is considered. Without prejudice to the argument as a full-fledged manufacturer carrying risk relating to capacity utilization, and hence adjustment is not demonstrated as warranted, the effect of difference in capacity utilization is eliminated by treating the depreciation expenses in case of each comparable as fixed costs, and computing the contribution at different level of capacity utilization. Accordingly, the adjusted PLI is determined adjusting for difference in capacity utilization in each case by comparing it with the assessee.” 33. Questioning the method adopted by the TPO in the present case, ld. AR for the assessee made various submissions in this regard and the same are extracted in para 2.3.2 of the order of the CIT(A). In the said submission, the assessee sought a direction from the CIT(A) to the Assessing Officer to accept the method used by the assessee to carry out ‘capacity utilization adjustment’ to the operating margins of the comparable companies identified by the assessee. The CIT(A) considering the same and

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directed the Assessing Officer to grant the “capacity utilization adjustment” by computing the formula specified in page 113 in the Book published by the Chamber of Tax Consultant, Mumbai in ‘Practical Guide to Indian Transfer Pricing’. 34. Before us, ld. DR for the Revenue relied on the decision of the Mumbai Bench of the Tribunal in the case of CIT vs. M/s Petro Araldite Pvt. Ltd. (35 taxmann.com 590) which is relevant for the proposition of making the adjustments on this account to the “profit margins of the comparables”. He read out the contents of paras 23 to 25 of the said order of the Tribunal (supra). For the sake of completeness, the same are extracted hereunder :- “23. The question that now arises is what is the proper method of making adjustment for difference in capacity utilization within the frame work given in Rule 10B. As already discussed by us, the difference in capacity utilization affects the profitability mainly because of the difference in rates at which the fixed overheads are absorbed or allocated depending on the level of capacity utilization. The example given by us clearly depicts this position. The said example shows that the allocation of fixed overheads at the capacity utilization of 50%, 60% & 80% is 40%, 33.33% & 25% respectively resulting in the profit margin of 10%, 16.67% and 25%. In our opinion, if the fixed overheads allocation or absorption of comparable is brought at the level of the assessee , it would nullify the effect of difference in capacity utilization on the profit margin. For example, if we take the profitability working at 50% capacity utilization as that of the tested party and at capacity utilization of 60% and 80% as that of the comparables and adjust the rate of allocation of fixed overheads of the comparables in order to bring the same at par (i.e. 40% of sales) with the tested party, the resultant position will be as under:- Net profit Rs.1 crore Rs. 2.00 crores Less additional allocation of Rs. 0.40 crores Rs.1.20 crores depreciation by taking the rate of fixed overheads at 40% of sales: Net profit after adjustment Rs. 0.60 crores Rs. 0.80 crores Profit margin after adjustment 10% 10% 24. The adjustment thus can be made to the profit margin of the comparables by allocating fixed overheads at the same rate at which fixed overheads are allocated in the case of the tested party. For example, in the case of a comparable having 80% capacity utilization, the rate of allocation of depreciation is 25% of the sales as against the rate of allocation of fixed overheads of 40% in the case of the tested party. If the adjustment is made in the profit margin of the said comparables by allocating more fixed overheads at 15% of sales to bring the rate of allocation of fixed overheads at par with that of the tested party, the profit of the comparable would be reduced by Rs. 1.20 crores thereby giving a net profit of Rs. 0.80 crores which would bring the profitability to 10%, i.e. at par with the tested party. Similarly, if the

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adjustment is made in the profit margin of a comparable having 60% capacity utilization by allocating more fixed overheads at 6.67% of sales to bring the rate of allocation of fixed overheads at par with that of the tested party, the profit of the said comparable would be reduced by Rs. 0.40 crores thereby giving a net profit of Rs. 0.60 crores which would bring the profitability to 10% i.e. at part with the tested party. 25. Having held that the adjustment on account of difference in capacity utilization is required to be made and having explained with illustration that the same can appropriately be made by absorbing or allocating fixed overheads such as depreciation on sales of the comparable at the same rate as that of the tested party, we are of the view that such absorption or allocations of fixed overheads on operating cost instead of sales would be more appropriate as the same will eliminate the effect of difference in profit margin or difference in level of stock of finished goods, if any, of the tested party and comparables.” 35. Therefore, rejecting the assessee’s method for quantifying the “capacity utilization adjustment” to the tested party, we direct the Assessing Officer to follow the judgement of the Jurisdictional High Court in the case of Petro Araldite (P.) Ltd. (supra). The said judgement is relevant for following proposition :- “(v) In the above view, taking into account the capacity utilization of the comparable, in the present facts, as it materially affects the profit margin, the invocation of Rule 10-B(1)(e)(iii) of the Rules, cannot be found fault with This is self evident position from the reading of the aforesaid provision that all aspects/difference between the international transactions and the comparable uncontrolled transactions which materially affects the net profit margin had to be taken into account so as to have the fair comparison while determining the ALP of the tested party’s transaction.” 36. Considering the above, we find this issue should be remanded to the file of the Assessing Officer to follow the precedent in existence on this issue and make the adjustment in any after granting a reasonable opportunity of being heard to the assessee. Accordingly, ground nos.1 and 2 stands allowed for statistical purposes. 37. Ground nos.3 and 4 relate to the restricting the TP adjustment to the international transactions with AEs only. Before us, ld. AR submitted that the issue now stands covered and hence the said grounds need to be

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allowed in favour of the assessee in view of the following binding judgments :- (i) DCIT vs. M/s Starlite (2010-TII-28-ITAT-MUM-TP); (ii) Abhishek Auto Industries Ltd. vs. DCIT (2010-TII-54-ITAT-DEL-TP); (iii) IL Jin Electronics (I) (P) Ltd. vs. ACIT (ITA No.483/2008); and, (iv) Tara Ultimo Pvt. Ltd. vs. ACIT (2010-TIOL-166-ITAT-Mum). 38. Mentioning that the Assessing Officer/TPO quantified the adjustments to the entire turnover of the assessee at the entity level, ld. AR stated that the same is not approved by series of decisions which are already discussed in connection with the additional ground raised by the assessee. 39. After hearing both the sides on this issue, we find the additional ground raised by the assessee relates to the issue raised in ground nos.3 and 4 of the assessee’s appeal. We have decided this issue relying on the binding judgement in favour of the assessee and in favour of restricting the adjustments only to the international transactions with AEs benchmarked by the TPO. The discussion in this regard is at paras 25 to 28 of this order while dealing with the additional ground. We have already decided the issue in favour of the assessee. Consequently, these ground nos.3 and 4 raised by the Revenue required to be dismissed. Therefore, the order of the CIT(A) is fair and reasonable on this issue and it does not call for any interference. Thus, ground nos.3 and 4 are dismissed. 40. In the result, the appeal of the Revenue is partly allowed for statistical purposes.

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