2025 (7) TMI 961 - AT - Income Tax

Disallowance u/s 40A(2)(a) - determination of the fair market value of purchases from related parties - assessee could not demonstrate that the purchases had been made from the related parties at an arm length price - HELD THAT - Section 92BA which defines specified domestic transactions and attracts transfer pricing documentation requirements was inserted with effect from Assessment Year 2013 14 but was made applicable for certain transactions only from Assessment Year 2017 18 onwards. Therefore for the year under consideration the assessee was not mandatorily required to maintain documentation as per transfer pricing regulations. Nonetheless the transaction remains amenable to scrutiny u/s 40A(2)(a) of the Act. Determination of fair market value u/s 40A(2)(a) requires a factual inquiry into the prevailing market rates of the relevant goods during the period of transaction. Considering that the assessee deals in precious metals and ornaments the prices of which are subject to daily fluctuations it was incumbent upon the AO to examine relevant market data available in the public domain or through comparable independent transactions before arriving at a conclusion regarding excessiveness. The lower authorities have neither referred to nor relied upon such objective market data to determine the fair value of the purchases in question. The approach adopted by the AO in computing disallowance solely based on the fall in gross profit rate without corroborating the same with market evidence cannot be sustained in law. The direction of the CIT(A) to apply an average gross profit rate over a three-year period in the absence of representation from the assessee and without due analysis of comparable market prices also lacks adequate justification. We are of the considered view that the matter requires re-examination. Accordingly the matter is restored to the file of CIT(A) with a direction to re-adjudicate the issue afresh after examining the fair market value of the purchases made from the related parties during the relevant period based on contemporaneous data. Appeal of the revenue is allowed for statistical purposes.

Summary

The core legal issue considered by the Tribunal is the determination of the fair market value of purchases made from related parties for the purposes of disallowance under Section 40A(2)(a) of the Income-tax Act, 1961. Specifically, whether the Assessing Officer (AO) was justified in disallowing expenditure on the ground that purchases from related parties were made at prices exceeding the arm's length price, and whether the Commissioner of Income-tax (Appeals) [CIT(A)] erred in directing the AO to adopt an average gross profit rate over three years to determine the disallowance.

Additional relevant issues include the applicability and interpretation of Section 92BA regarding specified domestic transactions and transfer pricing documentation requirements for the relevant assessment year, and the procedural fairness in the appellate process, including the requirement for adequate inquiry and opportunity to the assessee to present evidence.

On the primary issue of disallowance under Section 40A(2)(a), the Tribunal examined the legal framework which mandates that any expenditure incurred by the assessee that is excessive or unreasonable in relation to the fair market value of goods or services must be disallowed. The proviso to this section exempts specified domestic transactions at arm's length price from such disallowance, but this exemption was not mandatorily applicable for the assessment year under consideration (2013-14), as transfer pricing documentation requirements under Section 92BA became applicable only from assessment year 2017-18 onwards for certain transactions.

The AO had observed a significant decline in the gross profit rate from 4.98% in the previous year to 0.25% in the relevant year and, on the basis of this fall in profitability and the purchases from related parties totaling approximately Rs. 14.9 crores, disallowed Rs. 2.63 crores as excessive expenditure. However, the AO did not rely on any objective market data or comparable independent transactions to establish the fair market value of the goods purchased. The CIT(A) directed the AO to adopt an average gross profit rate over three years (2012-13 to 2014-15) for determining the disallowance, despite the assessee's non-appearance and lack of representation.

The Tribunal critically analyzed this approach, emphasizing that determination of fair market value under Section 40A(2)(a) requires a factual inquiry into prevailing market rates, especially given the nature of the goods-precious metals and ornaments-whose prices fluctuate daily. The Tribunal found the AO's reliance solely on the fall in gross profit rate without corroborating evidence from market data to be unsustainable in law. Similarly, the CIT(A)'s direction to average profitability over three years without adequate justification or consideration of market evidence was also found to be inadequate.

In support of its reasoning, the Tribunal referred to authoritative precedent from the Delhi High Court which underscored the obligation of the AO to conduct proper scrutiny and inquiry into facts, and the appellate authorities' role to ensure that assessments reach finality only after requisite facts are found. The cited judgment elaborated on the procedural safeguards under Section 250(4) of the Income-tax Act, allowing the CIT(A) to direct further inquiry to ascertain facts before disposal of appeal. The Court emphasized that the assessee bears an initial burden to provide some proof regarding the genuineness and arm's length nature of transactions, but the AO and appellate authorities must engage in a thorough inquiry, including examining market data and comparable transactions, before making adverse findings.

The Tribunal noted the absence of any attempt by the AO or the CIT(A) to examine contemporaneous market data or comparable independent transactions to determine fair market value. It also highlighted the procedural deficiency in the appellate proceedings, where the assessee was unrepresented but was not afforded an opportunity to present evidence or be heard before the CIT(A) directed the adoption of an average profit rate. The Tribunal underscored the principles of natural justice requiring that the assessee be given adequate opportunity to present its case and file relevant evidence before any adverse conclusion is drawn.

Consequently, the Tribunal set aside the CIT(A)'s order and restored the matter to the file of the CIT(A) with directions to re-adjudicate the issue afresh. The CIT(A) was instructed to examine the fair market value of the purchases from related parties based on contemporaneous market data and to provide the assessee a fair opportunity to present evidence. The appeal of the Revenue was allowed for statistical purposes, indicating that the matter requires further factual inquiry and cannot be conclusively decided on the existing record.

In summary, the Tribunal held that:

• The AO's disallowance under Section 40A(2)(a) based solely on a decline in gross profit rate without reference to market data is unsustainable.
• The CIT(A)'s direction to average profit rates over three years without due inquiry or evidence is also unjustified.
• Determination of fair market value in related party transactions involving precious metals requires examination of contemporaneous market prices or comparable independent transactions.
• Procedural fairness and principles of natural justice necessitate affording the assessee adequate opportunity to present evidence before adverse findings are made.
• The appellate authority has the power and duty under Section 250(4) to direct further inquiry to ensure proper fact-finding.
• The matter is remanded for fresh adjudication consistent with these principles.

Thus, the Tribunal preserved the fundamental legal principle that disallowance of expenditure under Section 40A(2)(a) must be grounded in objective market data and proper inquiry, and that the burden on the assessee to demonstrate arm's length pricing must be balanced with the AO's and appellate authorities' obligation to conduct a fair and thorough investigation before drawing adverse conclusions.