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Income Tax Appellate Tribunal, DELHI BENCH “F”: NEW DELHI
Before: SHRI AMIT SHUKLA & SHRI PRASHANT MAHARISHI
O R D E R PER AMIT SHUKLA, J.M.
The aforesaid appeal has been filed against impugned order dated 28.7.2014, passed by Ld. CIT (Appeals) XVIII, New Delhi in relation to the penalty proceedings u/s 271(1)(c) for assessment year 2002-03. In various grounds of appeal, assessee has challenged the levy of penalty of Rs. 94,58,080/- made on account of transfer pricing adjustment of Rs. 2,64,93,239/-.
The facts in brief qua the issue of transfer pricing adjustment are that, the assessee company was set up in May 1999 as a wholly owned subsidiary of ‘Royal & Sun Alliance IT Solutions Pvt. Ltd. UK’ which is one of the world’s largest multi-national insurance group with operations in over 50 countries. The assessee was mainly engaged in providing information technology services qua the RSA group and was also providing software development/IT solutions to RSA group of Companies. The assessee’s entire operation was wounded up in the financial year 2004-05. The international transactions undertaken by the assessee with its AE during the year were as under:-
Sl. International Method Value (in Rs.) No. Transactions 1. Software TNMM 115,334,358 development and maintenance services 2. Payment for TNMM 4,996,086 administrative services 3. Sharing of worldwide 4,086,439 network charges 4. Recovery of Expenses 7,185,363
The assessee during the year had incurred operating loss of (-)
13.23% on costs. In the TP study report, the assessee adopted the TNMM to justify the remuneration received by its AE for the software development activity and other international transactions were aggregated with this transaction. The comparable companies chosen from the public data brought out the arithmetic mean of the profit margin of the comparable at 13.41%. The auditors who prepared the TP study report recommended that assessee should target an operating profit margin of 13.41% from its operation. However, as noted by the TPO it is not clear as to how the assessee has determined the transfer price during the year. The TPO further observed that assessee was set up as 100% captive software service provider to its group companies (AEs) and there was no justification by the assessee to have incurred losses, more so when the auditors in the TP study report have recommended a target margin of 13.41%. Before making the transfer pricing adjustment, the TPO observed that; firstly, assessee was free to carry out software services for independent third party, though it was set up as captive software service provider; secondly, AEs have not entered into exclusivity contract with the assessee as it had to compete with other third party service provider to get the work from its AEs and the assessee company had to enter into price negotiations with its AEs to provide services at market competitive rates; thirdly, the assessee was a full risk bearing software development company and assessee did not bill its AEs on cost plus basis but on hourly rate basis; and lastly, the losses are attributable to the factors not related to international transactions.
He also noticed that assessee had not performed even a single project to any third party other than the RSA group even though it had the capacity to compete and obtain independent contracts. After detailed discussion, he concluded in the following manner for determining the arm’s length adjustment:-
"7. Conclusion:
In the light of the above-stated facts and discussions, it is fair to conclude that the assessee was set up as 100% captive software service provider for the RSA group to meet its IT needs. The assessee did not have an option to optimize its return on capital and costs by obtaining third party contracts. Its capital and resources were locked in to provide service only to RSA companies. The under utilization of capacity was not due to the inability of the assessee to get contract from open market but due to lack of assignment of adequate work to the assessee by RSA group companies. 7.1 The assessee has submitted revenue projections showing that if the capacity of the assessee had been utilized as per industry norms it would have earned 24% margin on costs. The crucial question is not whether the capacity was utilized but whether the under utilization was due to the market conditions or due to the control exercised by the Associated Enterprises. At a theoretical level, it can be argued that even if lucrative contracts would have come the assessee's way, it could not have taken them up due to its status of being a subsidiary of RSA group. This is contrary to risk reward matrix of an independent company operating in a free market scenario. Therefore, the assessee ought to be remunerated not only for the projects carried out but also for the costs incurred on keeping itself ready to perform services to only to its AEs.
Determination of Arm's Length Price The condition described above satisfy the conditions described in Section 92(2) which states, "Where in an international transaction two or more associated enterprise enter into a mutual agreement or arrangement contribution to any cost or expense incurred or to be incurred in 4
connection with a benefit, service or facility provided or to be provided the cost or expense shall be determined having regard to the arm's length price of any such benefit, service or facility as the case may be". 8.1 The arm's length margin for the service provided by the assessee has been appropriately determined by the assessee itself in the TP report. As stated earlier, the TP report had recommended to the assessee that it should target an operating profit margin of 13.41 % on costs. As the reasons given to justify the departure from this arm's length price are not persuasive, the remuneration received by the assessee from its AEs is to be adjusted upwards to bring it at arm's length. Total Costs incurred in providing Services to AEs - Rs. 5,12,89,936 Arm's Length Remuneration (costs plus 13.41 %) - Rs. 5,81,67,916 Remuneration received for providing Services to AEs -Rs.3,16,74,677 Amount of Adjustment to be made - Rs 2,64,93,239 8.2 The Assessing Officer, therefore, shall make an addition of Rs. 2,64,93,239 to the total income of the assessee.”
In the assessment order the AO has computed the income in the following manner:-
Income as per computation of Income filed With the return of Income STP Unit Non STP Business Total Income (-)1,41,28,369 (-) 7,35,849 (-) 1,48,64,218 Add Profit as discussed In the order u/s 92CA(3) Of TPO-II Rs. 2,64,93,239 (as per separate details Filed. The amount of each Unit is mentioned against Them) (-)2,20,98,604 (+)43,94,638 (+) 2,64,93,239 79,70,235/- 36,58,789/- 1,16,29,021/- Income of STP Unit Rs. 79,70,235 Is exempt u/s 10A for Nil The 2nd year Taxable income Income from Non –STP Business as computed Above Rs. 36,58,789/- Add (out of admn. Expenses Rs.12,19,124/- As discussed above Rs. 48,77,913 Add: Interest income being Income from other sources As added by the assessee in The computation of income Filed with the return Rs. 9,08,317 Total income Rs.57,86,283 Adjust b/s loss and depreciation of non-STP business For A.Y. 2000-01 and 2001-02 as per record and as per law A.Y. 2000-01 A.Y. 2001-02 Business loss Rs. 8,63,817 Rs. 8,02,615 Unabsorbed depn. Rs. 66,703 Rs. 10,12,130 Rs. 27,45,265 Net taxable income Rs. 30,41,018
In the first appeal the appeal of the assessee on TP adjustment stood confirmed and thereafter the matter was not agitated before the Tribunal.
Now the penalty u/s 271(1)(c) has been levied by the AO simply on the ground that the transfer pricing adjustment of Rs. 2,64,93,239/- has been confirmed by the Ld. CIT(A). In the impugned penalty order the Ld. CIT (A) though has incorporated entire submissions/ explanation of the assessee which is running into more than 34 pages, but has confirmed the penalty by merely stating that submissions of the assessee has been considered and the case law relied upon by the counsel are distinguishable on facts and therefore, assessee’s appeal deserves to be dismissed. Neither there is any finding on merits nor any rebuttal on the various contentions and explanations filed by the assessee.
Before us Ld. Counsel for the assessee, Shri Sanjay Kumar after narrating the entire facts, submitted that the entire transfer pricing adjustment made by the AO is based on pure hypothesis which is based on the reasoning that assessee did not had any option to optimise its return on capital and costs by obtaining third party contracts, because all its resources were locked in to provide service only to RSA Companies and the underutilisation of capacity was due to lack of assignment of adequate work to the assessee by the RSA group companies; and hence assessee ought to have been remunerated not only for the project carried out but also for the costs incurred on keeping itself ready to perform services to its AE. Thus, TPO has proceeded to determine the arm’s length price on the premise that even though assessee has not performed any services then also AE should have remunerated it because the entire capital resources of the assessee were not utilised. Mr Sanjay Kumar further submitted that the determination of arms length price has to be on the basis of a FAR analysis with uncontrolled transaction. If assessee’s margin which was actually a huge loss was not found to be acceptable, then TPO should have determined his arm’s length price under the manner provided under the Act and the prescribed methods as given under the Rules. On the reference of TP study report, he pointed out that it was a merely recommendation/ target which was suggested for which assessee should aim and achieve in future. It was not that something was proposed to be made in this year. Thus, the entire transfer pricing adjustment is without sans any basis and without following the proper procedure laid down under the Act/ Rules; and therefore, no penalty either for furnishing of inaccurate particulars or for concealment of income can be levied for such kind of TP adjustment.
8. Another important contention raised by the Ld. Counsel was that, after making the addition on account of ALP, the Ld. AO has ultimately given benefit of deduction u/s 10A while computing the income of the STP unit which is evident from the computation of income appearing in the assessment order. Thus, out of adjustment of Rs. 2,64,93,239/-, addition of Rs. 2,20,96,604/- has been adjusted in the STP unit and income has been determined at Nil after giving exemption u/s 10A. In this manner practically no addition has been made on account of TP adjustment to the tune of Rs. 2.21 crores and therefore, no penalty can be calculated for tax sought to be evaded.
Thus, he submitted that order of the AO and CIT (A) levying penalty u/s 271(1)(c) deserves to be vacated.
On the other hand Ld. DR strongly relied upon the order of the AO and CIT (A) and submitted that the onus was on the assessee to arrive at proper arm’s length price for the international transactions which has not been done and even the recommendation of the auditors in TP study report has not been followed. Under these facts the TPO has rightly made the TP adjustment and is also justified in levying the penalty. Regarding the other limb of the Ld. Counsel’s contention that ultimately the majority of the TP adjustment has been treated as exempt u/s 10A, he did not supported the order of the AO and submitted that this action of the AO was not correct, but ultimately the issue of penalty has to be seen on the quantum of addition proposed by the TPO.
We have heard the rival submissions and also perused the relevant finding given in the impugned orders. It is not in dispute that assessee is a wholly owned subsidiary of its foreign AE was set up as a 100% captive service provider to cater information technology services and software development /IT solutions to RSA group of companies.
There was an operating loss of 13.23% on the cost. Though TP documentation suggested the arm’s length price target of 13.41%, however it is not clear from the records as to whether any kind of adjustment was proposed in such TP documentation. Ld. TPO, however has proceeded to make the TP adjustment in a completely erroneous manner. His main plank for making the upward adjustment was that there was underutilisation of capacity by the assessee because of less orders given by the AE to assessee; and therefore, assessee should have been remunerated for idle capacity utilisation by the AE; and assessee should have been allowed to operate in an independent manner and it did not had any option to optimise its return on capital and cost by obtaining third party contracts. Such a reasoning for making the TP adjustment without carrying out independent analysis with comparable uncontrolled transactions cannot be sustained. Ld. TPO instead of benchmarking the transaction under the prescribed method and FAR analysis with uncontrolled transactions has proceeded with the hypothesis that if the full capacity of the assessee had been utilised it would have earned 24% margin on the cost and therefore, it is presumed that such an under capacity utilisation was due to the control exercised by the AE. Such an interpretation for determining of arm’s length price is unknown under the transfer pricing regulations either under the Income Tax Act or under the Rules. In case under utilization of capacity was the factor triggering ALP determination, then the ld. TPO should have identified the comparable in similar line, then would have analysed the capacity utilisation and made suitable adjustment.
Without such analysis the entire basis adopted by the TPO to make the TP adjustment is wholly vitiated not only on facts but also under the law.
Another bizarre approach of the AO while computing the income of the assessee is that, he has given deduction u/s 10A on such transfer pricing adjustment which is against the provision of law as proviso below section 92C(4) categorically provides that no such deduction u/s 10A is allowable for transfer pricing adjustments made u/s 92C. Be that as it may be, if the computation of the AO is taken into consideration, then addition for ALP to the extent of Rs. 2.21 crores has been given exemption and income has been computed at ‘nil’ in so far as STPL unit is concerned; and only Rs. 43.94 lacs addition has been made on account of TP adjustment in the assessment order. Under these facts ostensibly the penalty of Rs. 2.21 crores neither could have been levied nor could have been computed by the AO, because there is no tax sought to be evaded to the extent of this amount of adjustment. In any case the manner in which arm’s length price has been determined and TP adjustment has been made by the TPO, same is unsustainable in law and consequently there cannot be any question of furnishing of inaccurate particulars of income or any concealment of income. Further there is no finding or observation by the AO that the loss margin of 13.23% has been found to be incorrect. Simply because adjustment has been made on certain hypothesis that AE should have remunerated idle capacity utilisation and assessee was not allowed to carry out any contract with the third party in the open market and therefore, it should have earned more margin cannot be the basis for levy of penalty u/s 271(1)(c). Hence under these facts and circumstances, we hold that the penalty of Rs. 94,58,080/- is unsustainable and is directed to be deleted.
In the result appeal of the assessee is allowed.