2025 (5) TMI 1395 - 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 of INR 30, 264, 835/- 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 as held a comparable can be rejected on the basis of its size per se. In this view of the matter the authorities below 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-a-vis business with AEs. As also bearing in mind entirety of the case 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. Accordingly the ALP adjustment deserves to be deleted. We find no justification to interfere with the view as expressed.

Summary

The core legal questions considered in this appeal pertain primarily to the determination of the arm's length price (ALP) in international transactions under the Transfer Pricing provisions of the Income Tax Act, particularly:

1. Whether the Assessing Officer (AO) and Transfer Pricing Officer (TPO) were justified in making transfer pricing adjustments amounting to INR 30,264,835 on account of alleged non-arm's length pricing of engineering and design services rendered to associated enterprises (AEs).

2. Whether the Tribunal's directions to the AO/TPO regarding examination of the segregation of expenses between AE and non-AE segments were complied with and properly adjudicated.

3. The validity and reliability of the internal Transactional Net Margin Method (TNMM) adopted by the assessee to benchmark international transactions with AEs against transactions with non-AEs.

4. The appropriateness of the external TNMM method and the selection of comparable companies used by the AO/TPO and upheld by the Commissioner of Income Tax (Appeals) (CIT(A)).

5. The treatment of idle capacity adjustments claimed by the assessee in computing net profit margins.

6. The legal effect of the India-Netherlands Double Taxation Avoidance Agreement (DTAA) on the applicability of section 92 of the Income Tax Act in respect of transactions with the head office.

7. Whether the CIT(A) erred in dismissing the grounds of appeal as non-speaking, arbitrary, and factually incorrect.

Issue-wise Detailed Analysis:

1. Legitimacy of Transfer Pricing Adjustment of INR 30,264,835 on ALP Grounds

Legal Framework and Precedents: The provisions of Chapter X of the Income Tax Act govern transfer pricing adjustments, mandating that international transactions between associated enterprises be conducted at arm's length price. The Transactional Net Margin Method (TNMM), as prescribed under Rule 10B(1)(e) of the Income Tax Rules, is a recognized method for determining ALP by comparing net profit margins of controlled and uncontrolled transactions.

Court's Interpretation and Reasoning: The Tribunal had earlier remitted the matter to the AO/TPO to examine the segregation of expenses between AE and non-AE segments, emphasizing that the TPO's rejection of the assessee's internal TNMM on the ground of expense allocation was premature without proper verification. The AO/TPO, however, rejected the internal TNMM and applied external TNMM, making the impugned adjustment.

On appeal, the CIT(A) upheld the AO/TPO's approach, rejecting the internal TNMM on grounds including lack of separate manpower for segments, absence of audited segmental accounts, and the creation of an 'idle capacity' segment deemed artificial.

Key Evidence and Findings: The assessee maintained segmental accounts dividing business into AE, non-AE, and idle capacity segments, allocating costs on a man-hour basis. The TPO and CIT(A) found the idle capacity segment and internal TNMM unreliable due to lack of separate manpower and audit verification. The Tribunal, however, in a coordinate bench decision for AY 2008-09, held that segmental accounts need not be audited or maintained in the ordinary course for internal TNMM to be acceptable, so long as the net profit margins are computed on comparable bases.

Application of Law to Facts: The Tribunal emphasized that the size disparity between AE and non-AE transactions does not invalidate their comparability for internal TNMM benchmarking. It also held that vague allegations of manipulation or unfair allocation by the TPO lacked specific evidentiary support. The man-hour basis for cost allocation was found reasonable and consistent with the requirements of TNMM under Rule 10B(1)(e).

Treatment of Competing Arguments: The AO/TPO and CIT(A) argued that the absence of audited segmental accounts and separate manpower undermined the reliability of internal TNMM. The assessee countered with detailed submissions on cost allocation methodology and prior judicial pronouncements supporting internal comparables. The Tribunal sided with the assessee, finding the authorities' rejection arbitrary and unsubstantiated.

Conclusions: The Tribunal set aside the transfer pricing adjustment of INR 30,264,835, holding that the internal TNMM adopted by the assessee was valid and that no ALP adjustment was warranted.

2. Compliance with Tribunal Directions on Expense Segregation Between AE and Non-AE Segments

Legal Framework and Precedents: The earlier Tribunal order dated 31 October 2013 directed the AO/TPO to verify the segregation of expenses between AE and non-AE segments, allowing the assessee to justify the allocation and directing the AO/TPO to conduct a fresh determination of ALP.

Court's Interpretation and Reasoning: The AO/TPO issued show cause notices and sought justifications, but ultimately rejected the segregation on grounds including lack of working of idle capacity and auditor's comments in Form 3CEB. The CIT(A) upheld this rejection, finding the idle capacity segment artificial and the allocation unjustified.

Key Evidence and Findings: The assessee's explanation of idle capacity included man-hours lost due to leave, training (conducted internally), and idle time. The CIT(A) noted no separate manpower was assigned to segments and that training was not outsourced, concluding the idle capacity segment was not a distinct segment for transfer pricing purposes.

Application of Law to Facts: The Tribunal in the present appeal did not specifically re-adjudicate this issue in detail but relied on the coordinate bench decision and the Delhi High Court ruling that acceptance of internal comparables does not require segmental accounts to be audited or maintained in the ordinary course.

Treatment of Competing Arguments: The assessee argued that the Tribunal's earlier directions were not properly complied with and that the idle capacity segment was a valid cost center. The AO/TPO and CIT(A) rejected this on factual grounds. The Tribunal found the AO/TPO's rejection of internal comparables and expense segregation unjustified.

Conclusions: The Tribunal effectively held that the AO/TPO's and CIT(A)'s rejection of the internal TNMM and expense segregation was not in accordance with law and that the matter was rightly remitted earlier for fresh examination, which was not properly done.

3. Validity of Internal TNMM and Rejection of External TNMM and Comparable Selection

Legal Framework and Precedents: TNMM is an accepted method for benchmarking international transactions. Internal comparables, i.e., transactions with non-AEs, are permissible provided comparability criteria are met. External comparables must be functionally comparable and selected on objective criteria.

Court's Interpretation and Reasoning: The AO/TPO rejected internal TNMM due to segmental accounts not being audited and adopted external TNMM with selected comparables. The CIT(A) upheld this, finding minor functional differences permissible in comparables.

Key Evidence and Findings: The assessee contended that several external comparables chosen were functionally dissimilar, including companies engaged in different engineering and consultancy services. The CIT(A) found that the comparables broadly fell within overall engineering and technical services and that minor functional variations were acceptable under TNMM.

Application of Law to Facts: The Tribunal relied on the coordinate bench decision and High Court ruling that internal TNMM based on segmental accounts, even if unaudited, is acceptable and that the size difference between AE and non-AE transactions does not preclude comparability. The Tribunal found the rejection of internal TNMM and acceptance of external TNMM by lower authorities erroneous.

Treatment of Competing Arguments: The assessee argued for internal comparables based on transactions with non-AEs, while the AO/TPO and CIT(A) preferred external comparables, citing reliability concerns. The Tribunal found the AO/TPO's approach inconsistent with judicial precedents and the facts of the case.

Conclusions: The Tribunal held that internal TNMM was the appropriate method and that the external TNMM adjustment was unwarranted. The selection of external comparables was not accepted as a substitute for internal comparables.

4. Treatment of Idle Capacity and One-Time Expenses

Legal Framework and Precedents: Adjustments for idle capacity and extraordinary expenses are recognized in transfer pricing to ensure accurate reflection of arm's length price.

Court's Interpretation and Reasoning: The AO/TPO rejected the idle capacity adjustment on the basis that the assessee did not maintain separate segmental accounts and did not provide sufficient working. The CIT(A) upheld this rejection, finding the idle capacity segment artificial and connected to AE and non-AE segments.

Key Evidence and Findings: The assessee claimed idle capacity based on man-hours lost due to leave, training, and idle time, but acknowledged no separate manpower was assigned. The CIT(A) found training was internal and no external agency was involved, weakening the claim.

Application of Law to Facts: The Tribunal did not specifically adjudicate this issue in the present appeal, considering it academic in light of the decision to allow internal TNMM and delete the transfer pricing adjustment.

Treatment of Competing Arguments: The assessee argued for acceptance of idle capacity adjustment; the AO/TPO and CIT(A) rejected it on factual and evidentiary grounds. The Tribunal's silence indicates acceptance of the lower authorities' findings or deeming the issue moot.

Conclusions: The issue was not adjudicated further as it became academic after deletion of the transfer pricing adjustment.

5. Applicability of India-Netherlands DTAA and Section 92 of the Income Tax Act

Legal Framework and Precedents: The DTAA provisions override domestic law where applicable. Article 9 of the India-Netherlands DTAA excludes branch offices from its scope.

Court's Interpretation and Reasoning: The assessee contended that transactions with the head office should not be subjected to transfer pricing adjustments under section 92 as per DTAA. The CIT(A) did not adjudicate this ground.

Key Evidence and Findings: The ground was not pressed by the assessee and was dismissed accordingly.

Application of Law to Facts: No detailed analysis was undertaken due to non-pressing of the ground.

Treatment of Competing Arguments: Not applicable.

Conclusions: The ground was dismissed as not pressed and consequential.

6. General Grounds Regarding Non-Speaking Orders and Arbitrary Findings

Legal Framework and Precedents: Orders must be speaking and reasoned; arbitrary findings without basis violate principles of natural justice.

Court's Interpretation and Reasoning: The CIT(A) was alleged to have passed non-speaking and arbitrary orders. The Tribunal dismissed these general grounds as not requiring specific adjudication.

Key Evidence and Findings: The Tribunal found the substantive grounds more relevant and decided accordingly.

Application of Law to Facts: The general grounds were dismissed as lacking independent merit.

Treatment of Competing Arguments: Not applicable.

Conclusions: Grounds dismissed.

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 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 authorities below 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-`a-vis business with 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, are too sweeping and generalized to have any merits."

"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. Accordingly, the ALP adjustment of Rs 2,72,42,940 deserves to be deleted."

The Tribunal's final determination was to allow the appeal, set aside the transfer pricing adjustment of INR 30,264,835, and delete the addition made on account of ALP adjustments, thereby granting relief to the assessee. Other grounds became academic and were not adjudicated.