2025 (5) TMI 829 - AT - Income Tax

TP Adjustment - benchmarking the payment of royalty at NIL - AR submitted that the TPO s characterization of the assessee as a contract manufacturer is incorrect and the disallowance of royalty payments is unjustified - HELD THAT - TPO changed the stance and reclassified the assessee as a contract manufacturer. Accordingly the TPO held that the assessee was not liable to make royalty payments. The TPO also deemed the royalty payment a colorable device intended to reduce the tax liability of the flagship company of the Toyota Group in India i.e. TKML by diverting the royalty payment to the assessee company. Thereby the TPO disallowed the entire payment of royalty by taking the ALP at NIL. There is no change in the facts circumstances or functions of the assessee in the year under consideration compared to earlier years. Therefore in our considered opinion the principle of consistency should be applied. Accordingly considering the ruling of the Tribunal in the assessee s own case in previous years as discussed in the earlier paragraph we hold that TNMM should be adopted as the most appropriate method. The learned AO/TPO is directed to determine the ALP of the royalty payment in accordance with the said method. Hence the ground of appeal of the assessee is partly allowed for statistical purposes. Benchmarking the interest on outstanding receivables - Whether or not the outstanding receivables is an international transaction? - TPO rejected the assessee s contention that the receivables transaction should not be separately benchmarked as it was part of an overall business arrangement with the AE - HELD THAT - This issue is no longer res integra. Hon ble Bombay High Court took a view in the case of CIT v. Patni Computer Systems 2013 (10) TMI 293 - BOMBAY HIGH COURT on the amendment to section 92B of the Act by way of Finance Act 2012 with retrospective effect from 01/04/2002 that the interest on outstanding receivables is an international transaction and it certainly requires separate benchmarking. Rate of interest - PLR rate therefore would not be applicable and should not be applied for determining the interest rate. Furthermore the PLR rates are not applicable to loans to be re-paid in foreign currency. Ends of justice would be met by accepting the interest rate on similar foreign currency receivables/advances as LIBOR 200 points by applying the credit period of thirty days or as per agreement or invoice. Accordingly we direct the learned Assessing Officer/ learned TPO to re-compute the same. Hence the grounds of appeal of the assessee are hereby allowed for statistical purposes. Disallowance of gratuity expenses u/s 43B - assessment u/s 143(3) - HELD THAT - In the instant case the AO while finalizing the assessment under section 143(3) of the Act adopted the total income computed in the intimation issued under section 143(1) of the Act. By doing so the AO has effectively incorporated the disallowance into the assessment order. Therefore the assessee is justified in raising the ground of appeal against the said disallowance before the appellate authority including the DRP if the assessment route involved section 144C of the Act. Moreover the disallowance of gratuity expenses was factually and legally flawed. Section 43B allows deduction for gratuity expenses paid before the due date of filing return under section 139(1) of the Act. The assessee has provided evidence that the payment was made on 15th September 2020 i.e. before the due date and the same is duly reported in the Tax Audit Report. The failure to consider this evidence coupled with the absence of a show cause notice or opportunity of hearing amounts to a breach of natural justice. The CPC as well as the AO should have taken into account this compliance before disallowing the expense. The statute does not permit the collection of tax beyond what is legitimately due from the assessee. Taxation must be based on liability established under the law and merely because of a procedural lapse an assessee cannot be compelled to pay tax that it is not legally required to pay. In this case the assessee has provided documentary evidence showing that the gratuity payment was made before the due date of return filing making it allowable under section 43B of the Act. Therefore in our considered opinion merely the fact that the impugned disallowance was made in the intimation order u/s 143(1) of the Act and the assessee has not preferred appeal against the said intimation does means that assessee should be charged with taxes which he is not liable. We hold that the disallowance made u/s 143(1) of the Act having been adopted and merged into the regular assessment u/s 143(3) of the Act is very much appealable in the context of the present proceedings. The disallowance of gratuity expenses is unjustified both on merits and on procedural grounds. We direct the AO to delete the disallowance made under section 43B of the Act towards gratuity expenses as the payment was made within the statutory time and is otherwise allowable. Denial of taxes in foreign countries - HELD THAT - If the requisite documentation including Form 67 was furnished within the prescribed time then the assessee is entitled to the credit of taxes paid in foreign jurisdictions in accordance with the applicable legal provisions. Accordingly we direct the AO to verify the claim afresh examine the availability and timeliness of Form 67 and other supporting records and grant the appropriate foreign tax credit as per law. Hence the ground raised by the assessee is allowed for statistical purposes. Denial of credit for Dividend Distribution Tax (DDT) and the consequential levy of interest u/s 115P as computed in the assessment order passed u/s 143(3) r/w section 144C(13) - The matter requires proper verification by the AO. If the DDT payment as claimed was indeed made by the assessee on the date stated above and is supported by the challan and corresponding entries in the assessee s records then the credit of such payment must be granted and the consequential levy of interest under section 115P of the Act should be appropriately revised. Accordingly in the interest of justice and fair-play we restore the issue to the file of the AO with a direction to verify the DDT payment claim made by the assessee and allow the credit as per law. The AO shall also recompute interest under section 115P of the Act accordingly after granting due credit for the DDT if found in order. Hence this ground of appeal is allowed for statistical purposes. Levy of ad-hoc interest as reflected in the computation sheet forming part of the final assessment order - As observed that the said interest has been charged without any explanation or reasoning provided by the AO in the body of the order or in any supporting document - HELD THAT - In the absence of a clear basis or statutory provision supporting the computation the addition of interest in an ad-hoc manner cannot be sustained. Accordingly in the light of the above we find merit in the assessee s contention. The levy of interest must be supported by a specific provision of law and a clear rationale computation. We therefore set aside this issue to the file of the AO with a direction to verify the nature and basis of the interest amount and either provide a detailed justification for the same or delete the levy if found unsubstantiated. Accordingly this ground of appeal is allowed for statistical purposes.

Summary

The core legal questions considered in this appeal include: (1) Whether the characterization of the assessee as a contract manufacturer and consequent disallowance of royalty payments under transfer pricing provisions is justified; (2) The appropriate transfer pricing method for benchmarking royalty payments; (3) Whether outstanding receivables from associated enterprises constitute an international transaction requiring arm's length pricing and interest benchmarking; (4) The allowability of gratuity expenses disallowed under section 43B of the Income Tax Act; (5) The entitlement to foreign tax credit claimed but disallowed; (6) The entitlement to credit for Dividend Distribution Tax (DDT) paid and related interest levy under section 115P; and (7) The validity of ad-hoc interest levied without explanation.

Regarding the first issue, the transfer pricing authorities (TPO and DRP) reclassified the assessee from a licensed manufacturer to a contract manufacturer based on a functional and risk analysis. The TPO applied OECD guidelines to conclude that the assessee does not bear market risks or independently exploit technology to capture the market, as it supplies over 95% of its products to a related party (TKML) and follows its demand projections. The TPO found that royalty payments were unjustified for the assessee and should instead be borne by TKML, which benefits from the technology. The TPO also identified a cost reallocation within the Toyota group designed to shift royalty payments to Indian subsidiaries, distorting economic substance. Consequently, the TPO benchmarked the royalty payment at NIL, disallowing Rs. 45.83 crore in royalty payments as a transfer pricing adjustment.

The assessee contested this reclassification, arguing that it is a licensed manufacturer paying royalty under a valid agreement and bears market risks linked to TKML's demand fluctuations. The assessee contended that the TPO's functional analysis was flawed and inconsistent with judicial precedents, including a decision where similar contentions were rejected. The assessee also argued that payment of royalty for technical know-how is legitimate and consistent with business practice and prior years' assessments.

The Tribunal examined prior decisions involving the assessee's sister concerns, which had held the Transactional Net Margin Method (TNMM) as the most appropriate method for benchmarking royalty payments, rejecting the Profit Split Method (PSM) proposed by the TPO. The Tribunal referred extensively to OECD Transfer Pricing Guidelines, emphasizing that PSM is appropriate only when both parties contribute unique and valuable intangibles and share economically significant risks, which was not the case here. The assessee does not make unique contributions but uses technology licensed from the parent company. The Tribunal held that TNMM remains the most appropriate method and directed the AO/TPO to benchmark royalty payments accordingly, allowing the ground of appeal.

On the issue of outstanding receivables from associated enterprises, the TPO treated delayed payments as an international transaction under section 92B, requiring arm's length pricing of interest on delayed payments. The TPO rejected the assessee's argument that receivables are part of the primary transaction and do not constitute separate international transactions. The TPO benchmarked interest using the SBI PLR rate for domestic currency and LIBOR-based rates for foreign currency, resulting in a modest adjustment.

The assessee relied on judicial decisions to argue that outstanding receivables do not constitute separate international transactions and that credit terms are standard business practice. It contended that the delay in payments does not generate taxable income and that the transfer pricing provisions should not apply to hypothetical income. The DRP upheld the TPO's view, citing the Finance Act 2012 amendment to section 92B that explicitly includes deferred payments as international transactions. The DRP also referenced judicial decisions supporting the requirement to charge interest on extended credit periods.

The Tribunal referred to authoritative judicial pronouncements, including decisions of the Bombay High Court, which held that interest on delayed payments to associated enterprises is an international transaction requiring arm's length pricing. The Tribunal found that PLR rates are inappropriate for foreign currency transactions and directed the AO/TPO to recompute interest using LIBOR plus an appropriate margin, applying the agreed credit period. The ground was allowed for statistical purposes.

The disallowance of gratuity expenses under section 43B by the Central Processing Centre (CPC) and the DRP's refusal to adjudicate the issue was challenged. The assessee contended that payment was made before the due date for filing the return, making the expense allowable. It also argued that the AO did not issue a show cause notice, violating natural justice. The DRP held that it lacked jurisdiction over CPC adjustments and that the assessee's remedy lay before the Commissioner of Income Tax (Appeals).

The Tribunal disagreed with the DRP's jurisdictional view, relying on the principle of merger of intimation under section 143(1) with the regular assessment under section 143(3). The Tribunal cited judicial precedents holding that once a regular assessment is made, the intimation merges with it and the issues therein become appealable in the regular proceedings. The Tribunal further found the disallowance factually and legally unsustainable, as the assessee had paid gratuity within the prescribed time and submitted proof. The failure to consider evidence and absence of a show cause notice violated natural justice. The Tribunal allowed the ground and directed deletion of the disallowance.

On the foreign tax credit issue, the assessee claimed credit for taxes paid abroad, supported by Form 67. The CPC and AO disallowed the claim without examining the merits. The Tribunal found merit in the assessee's contention and directed the AO to verify the claim and grant credit as per law, allowing the ground for statistical purposes.

The denial of credit for Dividend Distribution Tax (DDT) paid and consequential interest under section 115P was also challenged. The assessee submitted proof of DDT payment and argued that failure to grant credit led to unjust interest charges. The Tribunal directed the AO to verify the payment and grant credit if found in order, recomputing interest accordingly, allowing the ground for statistical purposes.

Lastly, the Tribunal considered the levy of ad-hoc interest of Rs. 2,35,955/- without any explanation in the assessment order. The assessee argued the levy was arbitrary and unsubstantiated. The Tribunal found the contention justified, directing the AO to either provide detailed justification or delete the levy, allowing the ground for statistical purposes.

Significant holdings include the following verbatim excerpts and principles:

"A transactional profit split method may also be found to be the most appropriate method in cases where both parties to a transaction make unique and valuable contributions (e.g. contribute unique intangibles) to the transaction... On the other hand, a transactional profit split method would ordinarily not be used in cases where one party to the transaction performs only simple functions and does not make any significant unique contribution (e.g. contract manufacturing or contract service activities in relevant circumstances)." (OECD Guidelines)

"Once a regular assessment under Section 143(3) is made, the intimation under section 143(1) ceases to be relevant and merges with the assessment order, unless expressly sustained or modified by the AO."

"Interest on outstanding receivables from associated enterprises is an international transaction requiring arm's length pricing. Extending credit beyond the normal period is in substance granting a loan to the AE and must be benchmarked accordingly."

"Section 43B allows deduction for gratuity expenses paid before the due date of filing return under section 139(1). Failure to consider proof of payment and absence of show cause notice violates principles of natural justice."

Final determinations include: (1) The assessee is not a contract manufacturer; royalty payments are allowable and should be benchmarked using TNMM; (2) Interest on delayed receivables is an international transaction and must be benchmarked using appropriate foreign currency rates; (3) Gratuity expenses paid within prescribed time are allowable; (4) Foreign tax credit claims supported by documentation must be allowed; (5) Credit for DDT paid must be granted with consequential interest recalculated; (6) Ad-hoc interest levied without basis is unsustainable.