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Income Tax Appellate Tribunal, “A” BENCH : BANGALORE
Before: SHRI N.V. VASUDEVAN & SHRI VIKRAM SINGH YADAV, ACCOUNTANT MEMBE
O R D E R Per N.V. Vasudevan, Vice President
This is an appeal by the Assessee against the order dated 30.7.2008 passed by the CIT(Appeals)-IV, Bangalore, in relation to assessment year 2003-04.
Originally this appeal was dismissed by the Tribunal for the reason that there was a delay in filing appeal before the Tribunal and there was no reasonable or sufficient cause for such delay. This order of the Tribunal was set aside by the Hon’ble Karnataka High Court in its order dated 2.7.2018 in ITA 197/2017 and the Tribunal was directed by the said order to decide the appeal on merits.
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There are basically two issues that need to be adjudicated in this appeal. This first issue is with regard to Arm’s Length Price (ALP) in respect of an international transaction entered into between the Assessee and its Associated Enterprise (AE) under the provisions of Sec.92 of the Income Tax Act, 1961 (Act). The second issue is with regard to disallowance of a sum of Rs.33,14,764/- which was claimed as revenue expenditure in the profit and loss account. The sum was capital assets (tools) costing less than Rs.50,000/- each which was written off in the profit and loss account and claimed as revenue expenditure. The Assessee had before the AO also made a claim in its letter dated 2.11.2005 that in the event of the expenditure being treated as capital expenditure then the Assessee should be allowed depreciation. This alternative claim was not allowed by the AO. In this appeal, the Assessee has prayed only for the alternative relief. The second issue can therefore be decided by directing the AO to allow depreciation, which is to be allowed to an Assessee as a consequence, despite a claim for such depreciation not having been made specifically, as laid down in the decision of Mahendra Mills Ltd., 99 ITR 135 (SC). Thus we allow the alternative prayer of the Assessee for allowing depreciation.
As far as the first issue of determination of ALP is concerned, the facts are that the Assessee is a subsidiary of Molex India Limited, which company in turn is a subsidiary of Moles International Inc., USA. Both the Assessee and Molex International Inc., are part of the Molex Group. The Assessee imports raw materials, production and supplies of spares, manufactures tools and exports them, besides also importing machinery. 85.74% of sales of tools manufactured are exported to AE and the remaining are sold domestically. All the above transactions except sale of tools manufactured by the Assessee that are sold domestically, are with AE.
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The following were the international transactions:
Taxpayer has reported the following international transactions:
Import of raw materials, production supplies and spares Rs. 70,43,431 2. Export of tooling spares, housing, dyes & moulds Rs.4,26,78,290 3. Import of machinery Rs. 15,66,631 The financial results of the company for the year 2002-03 are as under:
Operating income : Sales (Domestic) 71,57,946 Exports 4,26,15,243 Scrap 26,180
Total 4.97,99,369
Manufacturing & other expenses 7,84,55,880 Depreciation 2,27,07,331 10,11,63,211
Loss 5,13,63,842 Other income 1,36,925
Total loss 5,12,26,917
The TPO issued a show cause notice dt. 07/03/2006 to the tax payer company calling for the tax payer _company's explanation as to why the arms length price of the international transactions should not be recomputed by adopting the average mean of the margins of the comparables.
The Assessee in its TP Study has justified the price received in the international transaction by comparing the gross margins of 5 comparable companies with Assessee’s margin on net sales and claimed that the price received was at Arms Length as follows:-
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“8.4.4 Margins The gross margins of comparable companies are: Sl.. Company Margin to sales No. 1 Addison and Company Limited 30.22 2 Electronica Machine Tools Limited 25.34 3 Kulkarni Power Tools Limited 27.17 4 Rapicut Carbides Limited 13.75 5 Taparia Tools Limited 20.32
Average 23.26 The principal activities of each comparable companies and financials as appearing in the database- Appendix 4 The margins of the final comparable companies based on the databases -Appendix 5 8.5 OECD Guidelines 8.5.1 Associated Enterprises, like any other independent, can sustain genuine losses, whether due to heavy start-up costs (emphasis supplied), unfavourable economic conditions, inefficiencies (emphasis supplied) or other legitimate business reasons. MITPL being a start up company and has realised loss due to inefficiencies in production utilisation. In this regard reliance is placed on the OECD guidelines (para 1.52) in this regard. 8.6 Margin of MITPL: The margins of MITPL as a percentage of net sales are as below: Particulars Rupees Manufacturing Revenue 49,773,188 41,959,834 Adjusted Cost of Production 7,813,354 MARGIN MARGIN/ COST (%) 18.62
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The margins of comparable companies are in the range of 13.75 to 30.22%. The arithmetic mean of the net margins of the comparable companies is at 23.26 % (excluding the loss making companies). 8. The TPO however computed ALP by taking the gross margin of the Assessee and comparing it with the gross margin of the comparable companies chosen by the Assessee in its TP study, as follows:-
“3.0 I have carefully considered the above submissions. I find that the gross margins computed in the above submissions do not contain all the direct costs and therefore, the same is re-computed taking into account all direct costs as appearing in P & L a/c and schedules thereto.
Sales 4,97,73,189 Less : Manufacturing expenses Material cost 2,89,98,985 Salaries waves & other allowances 5,3,01,704 Power, fuel, etc 64,27,244 Stores & packing material 21,93,504 Rates & taxes 6,428 Repairs & Maintenance of Machinery 1,31,06,810 Depreciation 2,27,07,331 8.87,42,006
Gross loss 3,89,68,817 3.1 As can be seen from the above, there is a clear gross loss. 3.2 The domestic sales constitute less than 15 % of the total sales. This leaves only exports which were made only to their associated enterprise. Therefore, it is clear that the price charged for the international transaction is not at arm's length. Therefore, the arm's length price of the international transaction is re- computed by taking into account the gross margin of the comparables selected in the TP document.
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4.0 The arm's length price of the international transactions is computed below :
The CIT(A) confirmed the action of the TPO, hence this appeal by the Assessee before the Tribunal.
The limited prayer of the Assessee in this appeal is for granting adjustment on account of capacity utilization of the Assessee and that of the comparable companies. It was brought to our notice by the learned counsel for the Assessee that in AY 2006-07 in IT (TP) A.No.1494/Bang/2010 order dated 18.10.2016 and for AY 2005-06 in IT (TP) A.No.770/Bang/2012 order dated 25.1.2017, this Tribunal remanded the issue of allowing adjustment on account of capacity utilization and following the same, the said issue should be remanded to TPO/AO for fresh consideration. The learned DR relied on order of CIT(A).
We have considered the rival submissions. In the orders of Tribunal in Assessee’s own case for AY 2006-07 & 2005-06 this Tribunal has considered and remanded similar issue to the TPO/AO for fresh consideration. In AY 2006-07, the Tribunal held as follows on this issue:-
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“ Regarding the adjustment on account of lower capacity utilization and working capital adjustment, we find that it is noted by the DRP in para 3.2 on page 3 of its order that the TPO highlighted the major cost shown in the P&L account was the depreciation which in the case of tax payer was about 20% of the total cost against an average of 3.5% in the case of comparables. Thereafter, it is noted by the DRP that neutralize this difference the TPO has considered PBDIT as PLI by following the Tribunal order in the case of Sechefenacker Motherson Ltd., Vs ITO(2009- TIOL-376-ITAT-Delhi. It is further noted by the DRP in the same para with regard to the claim of assessee for other costs such as employee cost, repair and maintenance cost, office supplies, filing fee etc., It has been observed by the TPO that these cases are slightly higher than the comparables in the ratio of about 7 to 6 but just because the costs were higher, adjustment could not be considered. In the light of these facts, now we consider the applicability of various judgments cited by the ld. AR of the assessee on this issue. First judgment cited is the Tribunal order rendered in the case of CIT Vs Class India Pvt.Ltd., in dated 12-08¬2015. Copy available on pages 701 -726 of the paper book, para no.9.3 to 10.2 of this Tribunal order available on pages 714 to 720 of the paper book are relevant for the present issue in dispute hence, these paras are reproduced herein below for the sake of ready reference; “9.3. Sub-rule (2) of Rule 10B provides that the comparability of an international transaction with an uncontrolled transaction shall be judged with reference to certain factors which have been enumerated therein. Rule 10B(3) states that an uncontrolled transaction shall be comparable to an international transaction, if either there are no differences between the two or a ‘reasonably accurate adjustment can be made to eliminate the material effects of such differences”. When we read sub- clauses(ii) & (iii) of Rule 10B(1)(e) in juxtaposition to sub- rules (2) & (3) of rule 10B, the position which emerges is that the net operating profit margin of comparable companies calls for adjustment in such a manner so as to bring both the international transaction and comparable cases at the same pedestal. In other words, if there are no differences in these two, then the average of the net
IT(TP)A No.839/Bang/2009 Page 8 of 11 operating profit margin of the comparable companies becomes a benchmark. However, in case there are some differences between the comparables and the assessee, then the effect of such differences should be ironed out by making suitable adjustment to the operating profit margin of comparables. That is the way for bringing both the transactions, namely, the international transaction and the comparable uncontrolled transactions, on the same platform for making a meaningful and effective comparison. The above analysis overtly transpires that the law provides for adjusting the profit margin of comparables on account of the material differences between the international transaction of the assessee and comparable uncontrolled transactions. It is not the other way around to adjust the profit margin of the assessee. In other words, the net operating profit margin realized by the assessee from its international transaction is to be computed as such, without adjusting it on account of differences with the comparable uncontrolled transactions. The adjustment, if any, is required to be made only in the profit margins of the comparables. 9.4. Reverting to the facts of the instant case, we find that the authorities below have adjusted the operating costs of the assessee in allowing the capacity adjustment. As against that, the correct course of action provided under the law is to adjust the operating costs of the comparable and their resultant operating profit. There is hardly need to accentuate that there can be no estoppel against the law. Once the law enjoins for doing a particular thing in a particular manner alone, it is not open to anyone to adopt a contrary or different approach. As the authorities below have adopted a course of action in allowing adjustment, which is not in consonance with law, we cannot approve the same. The impugned order is set aside and the matter is restored to the file of the TPO/AO for giving effect to the amount of idle capacity adjustment in the operating profit of the comparables and not the assessee. ii. How to compute capacity utilization adjustment under TNMM : - 10.1. Under the TNMM, the ALP of an international transaction is determined by computing and comparing the percentage of operating profit margin realized by the IT(TP)A No.839/Bang/2009 Page 9 of 11 assessee with that of the comparables. We have noticed above that the difference in the capacity utilizations is an important factor, which needs to be adjusted. No mechanism has been given under the Act or the rules for computing the amount of capacity utilization adjustment. 10.2. On an overall understanding, we feel that under the TNMM, the first step in granting capacity utilization adjustment is to ascertain the percentage of capacity utilization by the assessee and comparables. There can be no difficulty in working out these percentages. The second step is to give effect (positive or negative) to the difference in the percentage of capacity utilizations of the assessee vis-à-vis comparables, one by one, in the operating profit of comparables by adjusting their respective operating costs. Operating costs can be either fixed or variable or semi-variable. One needs to split semi-variable costs into the fixed part and variable part. In so far as the variable costs and the variable part of the semi-variable costs are concerned, these remain unaffected due to any under or over utilization of capacity. Accordingly, such variable operating costs remain unchanged. The adjustment is called for only in respect of the fixed operating costs and fixed part of semi-variable costs. Such costs are scaled up or down by considering the percentage of capacity utilization by the assessee and such comparable. It can be illustrated with the help of a simple example. Suppose the fixed costs incurred by a comparable (say, A) are Rs. 100 and it has capacity utilization of 50% as against the capacity utilization of 25% by the assessee. The above percentages show that the assessee has incurred full fixed costs with 25% of the utilization of its capacity, as against A incurring full fixed costs with 50% of its capacity utilization. This divulges that the assessee has incurred relatively more fixed costs and A has incurred lower costs. In order to make an effective comparison, there arises a need to obliterate the effect of this difference in capacity utilizations. It can be done by proportionately scaling up the fixed costs incurred by A so as to make it fully comparable with the assessee. This we can do by increasing the fixed costs of A to Rs. 200 (Rs.100 into 50/25) as against the actually incurred fixed costs by it at Rs.100. When we compute operating profit of A by substituting the fixed costs at Rs.200 with the actually incurred at Rs.100, it would mean that the fixed costs
IT(TP)A No.839/Bang/2009 Page 10 of 11 incurred by the assessee and A are at the same capacity utilization. There can be converse situation as well. Suppose the fixed costs incurred by a comparable (say, B) are Rs. 100 and it has capacity utilization of 25% as against the capacity utilization of 50% by the assessee. The above percentages show that the assessee has incurred full fixed costs at 50% of the utilization of its capacity, as against B incurring full fixed costs at 25% of the capacity utilization. This deciphers that the assessee has incurred relatively lower fixed costs and B has incurred higher costs. This difference in capacity utilizations can be eliminated by proportionately scaling down the fixed costs incurred by B so as to make it fully comparable. This we can do by reducing the fixed costs of B to Rs. 50 (Rs.100 into 25/50) as against the actually incurred fixed cost by it at Rs.100. When we compute operating profit of B by substituting the fixed costs at Rs.50 with the actually incurred at Rs.100, it would mean that the fixed costs incurred by the assessee and B are at the same capacity utilization level. From the above paras of the Tribunal order, it is seen that the Tribunal has given a detailed guidelines as to how to make or grant capacity utilization adjustment. Hence, we feel it proper that this matter also should go back to the file of the AO/TPO for granting capacity utilization adjustment as per the guidelines given by the Tribunal in the case of DCIT Vs Class India Pvt.Ltd., (Supra). It is ordered accordingly.”
The said directions were again approved in Assessee’s own case in the appeal for AY 2005-06 also.
Accordingly, following the order of the Tribunal, we restore the matter to the file of the AO to re-adjudicate the issue of lower capacity utilization and working capital adjustment in the light of the findings of the Tribunal in Assessee’s own case for AY 2006-07. According the order of the CIT(A) is set aside and the matter is restored to the AO/TPO in terms indicated in the order for AY 2006-07.
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In the result, the appeal is partly allowed.
Pronounced in the open court on this 25th day of September, 2019.