2024 (5) TMI 1570 - AT - Income Tax

TP Adjustment - external TNMM resulting adjustment on account of ALP of international transactions - HELD THAT - We find merit in the argument of the Ld. Counsel that no adjustment on account of ALP of international transactions is called for. We have given a thoughtful consideration to the entire facts of the case and submissions/contentions/arguments of both parties and are of the considered view that this issue is squarely covered by the decision of the Hon ble Delhi High Court in case of the assessee 2024 (9) TMI 739 - DELHI HIGH COURT . We therefore following the reasoning given in case of the assessee supra set aside the order of the Ld. CIT(A) and delete the adjustment on account of ALP of international transactions - Decided in favour of assessee.

Summary

The core legal questions considered in this appeal pertain primarily to the determination of the arm's length price (ALP) under transfer pricing provisions, specifically:

1. Whether the Assessing Officer (AO) and Commissioner of Income Tax (Appeals) [CIT(A)] erred in making and upholding transfer pricing adjustments in respect of international transactions involving provision of engineering and design services.

2. The validity and reliability of the internal Transactional Net Margin Method (TNMM) adopted by the assessee for benchmarking international transactions, including the treatment of segmental profit and loss accounts and the claim of idle capacity adjustment.

3. The appropriateness of the external TNMM method and the selection and comparability of external comparable companies used by the AO/TPO and upheld by the CIT(A).

4. Compliance with directions of the Income Tax Appellate Tribunal (ITAT) regarding examination of the segregation of expenses between associated enterprises (AE) and non-AE segments.

5. Applicability of the India-Netherlands Double Taxation Avoidance Agreement (DTAA) vis-`a-vis the provisions of section 92 of the Income Tax Act in relation to transactions with the head office.

6. Whether the CIT(A) erred in not allowing the benefit of the permissible tolerance range under proviso to section 92C(2) of the Act.

Issue-wise Detailed Analysis:

1. Legitimacy of Transfer Pricing Adjustments and ALP Determination

The legal framework governing this issue is Chapter X of the Income Tax Act, which mandates that international transactions between associated enterprises be conducted at arm's length price. The Transfer Pricing Officer (TPO) had made an adjustment of INR 30,264,835 on account of ALP, rejecting the assessee's internal TNMM method and segmental accounts.

The ITAT had earlier remitted the matter to the AO/TPO with directions to examine the segregation of expenses between AE and non-AE segments, emphasizing that the TPO must verify the authenticity of the expense allocation and allow the assessee a reasonable opportunity to be heard. The Tribunal clarified that if the TPO found the segregation not authentic, alternative methods could be adopted.

In the subsequent proceedings, the TPO rejected the internal TNMM on the ground that the segmental accounts were not audited and the idle capacity adjustment was not substantiated. The CIT(A) upheld this rejection, holding that the idle capacity segment was artificially created and that the AE and non-AE segments were homogenous with no separate manpower, rendering the internal TNMM unreliable.

The assessee challenged this, contending that the allocation was on a man-hour basis and that the idle capacity segment was a genuine reflection of non-utilized manpower hours due to leave, training, etc.

The Tribunal, relying on a coordinate bench decision for AY 2008-09 and the subsequent Delhi High Court ruling, held that it is not necessary for internal comparables to be audited or maintained in the normal course of business for TNMM application. The key requirement is that net profit margins for controlled and uncontrolled transactions be computed on the same basis with appropriate comparability adjustments.

The Tribunal found the TPO's rejection of segmental accounts on the basis of non-audit and alleged manipulation to be sweeping and unsubstantiated. The allocation of expenses on man-hour basis was considered reasonable. Further, the small size of non-AE transactions did not by itself render them incomparable with AE transactions.

Thus, the Tribunal concluded that the internal TNMM method adopted by the assessee was valid and that the ALP adjustment of INR 30,264,835 was unwarranted.

2. Treatment of Idle Capacity Adjustment and Segmentation of Costs

The assessee's claim of idle capacity adjustment was based on the premise that certain manpower hours were not utilized due to leave, training, or lack of work, and such costs should be excluded from the cost base for determining net profit margins.

The AO/TPO and CIT(A) rejected this claim on the ground that no separate manpower was assigned to the idle capacity segment and training was internal, not outsourced. The CIT(A) held that the idle capacity segment was artificially created and intrinsically connected to AE and non-AE segments, thus not constituting a separate segment for transfer pricing purposes.

The Tribunal did not specifically adjudicate this issue in the present appeal, as it was rendered academic by the acceptance of the internal TNMM method and deletion of the ALP adjustment. However, the earlier ITAT order had directed examination of such claims, and the Tribunal's reliance on the prior decision suggests that such adjustments must be substantiated with credible data and proper allocation methodology.

3. Validity of External TNMM and Selection of Comparable Companies

The AO/TPO, after rejecting the internal TNMM, applied the external TNMM method using selected comparable companies. Some comparables were excluded due to related party transactions or abnormal profits.

The assessee contended that several selected comparables were functionally dissimilar and thus not appropriate for benchmarking. The CIT(A) held that minor functional differences are permissible under TNMM and confirmed the selection of comparables based on business profiles aligning with engineering and technical consultancy services.

The Tribunal, however, did not uphold the external TNMM adjustment in the present appeal, as the internal TNMM was accepted and the ALP adjustment deleted. The Tribunal's earlier observations emphasize that comparability must be carefully examined, but in this case, the internal comparables sufficed.

4. Compliance with ITAT Directions Regarding Expense Segregation

The ITAT had remitted the matter to the AO/TPO with specific directions to examine the segregation of expenses between AE and non-AE segments and verify the authenticity of the claimed segmentation.

The AO/TPO issued show cause notices and examined submissions but ultimately rejected the segregation due to lack of supporting working for idle capacity and absence of separate segmental accounts.

The CIT(A) upheld the TPO's findings, but the Tribunal's analysis in the present appeal found that the TPO and CIT(A) erred in disregarding the allocation methodology and the segmental data provided by the assessee.

The Tribunal emphasized that the TPO's power to determine ALP should not be eclipsed by mere procedural deficiencies if the allocation basis is reasonable and verifiable.

5. Applicability of DTAA Provisions vis-`a-vis Section 92 of the Act

The assessee raised the issue that transactions with the head office should not be subject to transfer pricing adjustments under section 92 because the India-Netherlands DTAA excludes branch offices from Article 9 (associated enterprises), thus overriding domestic law.

The CIT(A) did not adjudicate this ground, and the assessee did not press this issue in the appeal before the Tribunal, resulting in dismissal of this ground as not pressed and consequential.

6. Benefit of Tolerance Range under Proviso to Section 92C(2)

The assessee contended that the CIT(A) erred in not allowing the benefit of the +/- 5% tolerance range provided under the proviso to section 92C(2) of the Income Tax Act.

This ground was also dismissed along with other general grounds by the Tribunal, given the acceptance of the internal TNMM and deletion of the ALP adjustment.

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."

"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 authorities below were 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 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."

"The TPO indeed erred in rejecting the segmental accounts and thus declining to accept the internal comparable."

"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."

"The ALP adjustment of Rs 30,264,835 deserves to be deleted."

The Tribunal set aside the CIT(A) order and deleted the transfer pricing adjustment of INR 30,264,835 made on account of ALP of international transactions. Other grounds raised by the assessee became academic and were not adjudicated. The appeal was allowed accordingly.