2014 (3) TMI 23 - AT - Income Tax

Transfer pricing adjustment Services to Associated Enterprise Rejection of analysis for determination of ALP of International transaction - Held that - All that is necessary for the purpose of computing arm s length price under TNMM on the basis of internal comparables is computation of net profit margin subject to comparability adjustments affecting net profit margin of uncontrolled transactions on the same parameters for the transactions with AEs as well as Non AEs i.e. independent enterprises and as long as the net profits earned from the controlled transactions are the same or higher than the net profits earned on uncontrolled transactions no ALP adjustments are warranted - It is not at all necessary that a computation should be based on segmental accounts in the books of accounts regularly maintained by the assessee and subjected to audit - the authorities below in error in rejecting the segmental results on the ground that the segmental accounts were not audited and that these segmental accounts were not maintained in the normal course of business. The allocation of expense is on the man hour basis which is quite fair and reasonable and that every person has to punch in hours on a specific project - We have also noted that all these details and expense allocation basis were also before the TPO and even then no specific defects were pointed out by the TPO - the TPO indeed erred in rejecting the segmental accounts and thus declining to accept the internal comparable - the size of the uncontrolled transaction or transactions being smaller by itself does not make these transactions incomparable with the transactions in controlled conditions - Size of the comparable does matter in entity level comparison because scale of operations substantially vary and so does the underlying profitability factor but in a transaction level comparison within the same entity mere difference in size of the uncontrolled transactions does not render the transaction incomparable thus the authorities were clearly in error in rejecting the internal comparable i.e. profitability of assessee s transactions with non AEs on the ground that the volume of business with non AEs was too small vis- -vis business with AEs - the assessee was quite justified in adopting internal TNMM and comparing the profit earned on its transactions with AEs with profit earned with non -AEs Decided in favour of Assessee. Addition on sales/services rendered by Head Office Held that - In the absence of assessee s cooperation by submission of requisite information the Assessing Officer had no option except to resort to the addition on estimate basis Following the decision as decided in assessee s own case for the previous year the same has been decided in favour of Assessee thus the addition made is set aside Decided in favour of Assessee.

The core legal questions considered by the Appellate Tribunal in this case primarily revolve around the determination of arm's length price (ALP) under transfer pricing regulations and the attribution of income to a permanent establishment (PE) in India. The key issues are:

1. Whether the Assessing Officer (AO), Transfer Pricing Officer (TPO), and Dispute Resolution Panel (DRP) erred in rejecting the assessee's internal Transactional Net Margin Method (TNMM) analysis based on segmental profit and loss accounts for associated enterprise (AE) and non-AE segments.

2. Whether the segmental profit and loss accounts prepared by the assessee, but not audited or maintained in the ordinary course of business, could be relied upon for transfer pricing purposes.

3. Whether the size disparity between the non-AE transactions (internal comparables) and AE transactions justifies rejection of the internal comparables in determining ALP.

4. Whether the AO erred in making an addition of INR 86,571,076 on account of sales/services rendered by the head office, attributing 50% of those receipts to the Indian PE on an ad-hoc basis.

5. Ancillary grounds that are general or did not require specific adjudication.

Issue-Wise Detailed Analysis

Issue 1 & 2: Rejection of Assessee's Internal TNMM and Segmental Accounts

Relevant Legal Framework and Precedents: The determination of ALP under the Income Tax Act, 1961, particularly sections 92 to 92F, and Rule 10B(1)(e) of the Income Tax Rules, which prescribes the Transactional Net Margin Method (TNMM). TNMM requires comparison of net profit margins realized by the enterprise from international transactions with those realized from comparable uncontrolled transactions, using the same base (costs incurred, sales effected, or assets employed).

Court's Interpretation and Reasoning: The Tribunal emphasized that it is not mandatory for the net profit computations used for internal comparables to be based on audited accounts or books maintained regularly in the ordinary course of business. The essential requirement is that the net profit margin computations for both AE and non-AE transactions be made on the same parameters, subject to comparability adjustments.

The Tribunal found the AO, TPO, and DRP erred in rejecting the segmental accounts solely because they were not audited or maintained in the normal course. The TPO's generalized allegations that the segmental accounts were manipulated or artificially allocated to show higher profitability in AE transactions were considered sweeping and unsubstantiated.

Key Evidence and Findings: The assessee had prepared segmental accounts reflecting three segments: business with AEs, business with non-AEs, and idle capacity. The allocation of expenses was on a man-hour basis, which the Tribunal found to be fair and reasonable. The TPO had not pointed out any specific defects in the expense allocation method despite having these details before him.

Application of Law to Facts: Since the assessee's margin on AE transactions (40.68%) was higher than on non-AE transactions (29.02%), the internal TNMM benchmark supported acceptance of the ALP claimed by the assessee. The Tribunal held that the rejection of internal comparables on the ground of lack of audit or normal course maintenance was erroneous.

Treatment of Competing Arguments: The authorities below rejected internal comparables due to the small size of non-AE transactions and the absence of audited segmental accounts. The Tribunal countered that size alone does not invalidate comparability within the same entity and that mere difference in size does not render transactions incomparable. Further, the Tribunal rejected the argument that segmental accounts not maintained in the ordinary course cannot be relied upon.

Conclusions: The Tribunal allowed the use of internal TNMM based on segmental accounts prepared by the assessee, deleted the transfer pricing adjustment of INR 2,72,42,940, and held that the ALP was correctly determined by the assessee.

Issue 3: Addition on Account of Sales/Services Rendered by Head Office Attributable to Indian PE

Relevant Legal Framework and Precedents: The principles governing income attribution to a PE under the Income Tax Act and the arm's length principle under transfer pricing regulations.

Court's Interpretation and Reasoning: The AO had made an addition of INR 86,571,076 by attributing 50% of the head office receipts to the Indian PE on an ad-hoc basis, using an arbitrary 25% gross profit rate. The Tribunal noted that this issue was covered in favor of the assessee by a coordinate bench's earlier ruling in the assessee's own case for the assessment year 2006-07.

Key Evidence and Findings: The assessee disputed the attribution, arguing that once the PE was remunerated at arm's length (which was addressed in the transfer pricing adjustment), no further income should be attributed. The AO's addition was based on estimation without supporting material or basis.

Application of Law to Facts: The Tribunal followed the earlier coordinate bench decision and held that the ad-hoc addition lacked basis and was not justified, especially when the PE's remuneration was already determined at arm's length.

Treatment of Competing Arguments: The Department argued non-cooperation by the assessee necessitated the addition. However, the Tribunal gave precedence to the coordinate bench's ruling and the principle that no double taxation or unwarranted addition should be made once arm's length remuneration is established.

Conclusions: The Tribunal deleted the addition of INR 86,571,076 made on account of head office sales/services attributable to the Indian PE.

Issue 4 & 5: General Grounds

These grounds were either general in nature or did not require specific adjudication on the facts of the case and were accordingly not addressed in detail by the Tribunal.

Significant Holdings

"It is not at all necessary, as the authorities below seem to suggest, that such net profit computations, in the case of internal comparables (i.e. assessee's transactions with independent enterprise), are based on the audited books of accounts or the books of accounts regularly maintained by the assessee. In our considered view, all that is necessary for the purpose of computing arm's length price, under TNMM on the basis of internal comparables, is computation of net profit margin, subject to comparability adjustments affecting net profit margin of uncontrolled transactions, on the same parameters for the transactions with AEs as well as Non AEs."

"The vague generalizations by the TPO to the effect that these accounts are manipulated, that allocation basis of expenses is unfair and that these accounts conceal true profitability, we find that these observations are too sweeping and generalized the observations to have any merits."

"The size of the comparable does matter in entity level comparison because scale of operations substantially vary and so does the underlying profitability factor, but in a transaction level comparison within the same entity, mere difference in size of the uncontrolled transactions does not render the transaction incomparable."

"In none of these cases, a comparable can be rejected on the basis of its size per se."

"Respectfully following views of the coordinate bench on this issue in respect of an earlier assessment year, we delete the impugned addition of Rs 86,571,076."

The Tribunal's final determinations were that the transfer pricing adjustment of INR 2,72,42,940 was not justified and was deleted; the ad-hoc addition of INR 86,571,076 attributed to the Indian PE was also deleted; and the appeal was allowed on these grounds. The Tribunal upheld the principle that internal comparables based on segmental accounts prepared for transfer pricing purposes, even if not audited or maintained in the ordinary course, can be relied upon if the methodology is fair and reasonable. It also reaffirmed that size disparities alone do not disqualify internal comparables and that arbitrary additions without basis cannot be sustained.

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