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2016 (3) TMI 1121 - ITAT PUNE

2016 (3) TMI 1121 - ITAT PUNE - TMI - Transfer pricing adjustment - AO rejecting functional (capacity utilization) adjustment - Capacity adjustment should be allowed in whose hands? - Held that:- The authorities below have adjusted the operating costs of the assessee in allowing the capacity adjustment. As against that, the correct course of action provided under the law is to adjust the operating costs of the comparable and their resultant operating profit. There is hardly need to accentuate th .....

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profit of the comparables and not the assessee. - How to compute capacity utilization adjustment under TNMM - Held that:- the capacity utilization adjustment has to be granted where there has been under utilization or lower utilization of the capacity. In the facts of the present case, we deem it appropriate to remit the issue back to the file of Assessing Officer to decide this issue afresh after considering the submissions of the assessee, documents on record and decisions of the Tribunal .....

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ds a revisit to the Assessing Officer. The Assessing Officer after considering the submissions of the assessee and documents on record shall decide the issue afresh in the light of the decisions discussed above. Accordingly, this ground of appeal of the assessee is allowed for statistical purpose. - Benefit of 5% in transfer pricing adjustment u/s. 92C(2) - Held that:- In view of the newly inserted sub-section (2A) to section 92C the assessee is not eligible to claim the benefit of 5% in .....

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e assessee against the order of Commissioner of Income Tax (Appeals)-I, Pune dated 30-06-2011 for the assessment year 2004-05. 2. The brief facts of the case as emanating from the records are: The assessee company is a subsidiary of CVJV Inc. USA. The assessee is engaged in providing Information Technology Enabled Services (ITES). The total issued and subscribed shares of the assessee are 11,33,329 out of which the holding company is having 11,33,309 shares. The remaining 20 shares are held by a .....

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sessing Officer observed that the assessee has carried out international transactions of more than ₹ 5 Crores. Therefore, he referred the matter to the Transfer Pricing Officer (TPO) u/s. 92CA of the Income Tax Act, 1961 (hereinafter referred to as the Act ). The assessee during the period relevant to the assessment year under consideration had shown total sales of ₹ 11,07,77,000/- out of which international transactions with its AE were to the tune of ₹ 11,07,46,207/-. Apart f .....

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Revenue . In the TP report the assessee shows loss of 2.09% on sales as compared to the arithmetical mean of the operating margin to sales of the comparable companies, considering average for three years, at 4.85%. 2.1 The assessee while determining operating profit made adjustment for the under utilization of the working capacity at 29% and under utilization of manpower by 40%. After making the adjustment the assessee reworked its operating margin on sales at 14.71%. However, the TPO rejected .....

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f the comparables at 12.04%. The assessee had computed average operating margin of the comparable companies for the financial year 2003-04 at (-) 15.36%. The assessee s contention is that if aforesaid average operating margin of the comparables is considered, then the operating margin earned by the assessee (-) 2.09% is greater than the average operating margin of the comparable companies. The TPO after exclusion of two loss making companies and rejecting the under utilization of capacity adjust .....

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acity and manpower and exclusion of two companies, F I Sofex Limited and Fortune Informatics Limited from the list of comparables. The Commissioner of Income Tax (Appeals) vide impugned order rejected both the grounds of the assessee. Now, the assessee is in second appeal before the Tribunal assailing the findings of the Commissioner of Income Tax (Appeals). 3. The assessee has raised following grounds in appeal: 1. General: 1.1. The honorable CIT (A) erred in law and on the facts and in circums .....

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pellant 2.1 The honorable CIT (A) erred in law and on the facts and in circumstances of the case in rejecting the functional adjustment made by the Appellant to its Profit Level Indicator. 3. Rejection of two comparable companies from the Transfer Pricing analysis 3.1 The honorable CIT (A) erred on the facts and in circumstances of the case in confirming the rej ection of the independent comparable companies "F I Sofex Ltd." and Fortune Informatics Ltd. (now known as "Intense Tech .....

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grounds of appeal is without prejudice to the other. 6. The Appellant reserves the right to amend, alter or add to the grounds of appeal. 4. Shri Shri Ketan Ved and Shri Vishal Solanki appearing on behalf of the assessee submitted that the authorities below have erred in not granting the capacity under utilization adjustment. The ld. AR submitted that while calculating operating margin the fixed costs have been adjusted to the extent of capacity under utilized. The assessee company has built up .....

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ining costs to fulfill their requirements and such other incidental costs. All these things resulted in loss for the year on account of under absorption of fixed costs incurred for increasing capacity and building up new clientele. Since, the capacity of the company has been under utilized, fixed costs to the extent of under utilization of capacity have not been considered for the purpose of calculation of operating margin earned by the assessee company. The ld. AR referred to page 181 of the pa .....

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ost. The ld. AR referred to the contract between the CVJV Inc. USA and the assessee for the export of Embroidery Software design development effective from 01st April, 2003 at pages 226 to 228 of the paper book. The ld. AR also furnished revised PLI computation after adjusting the salary and employee cost of the assessee and the comparable companies. The ld. AR placed reliance on the following decisions of the Tribunal in support of his contentions that capacity utilization adjustment should be .....

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comparables on the ground that they are loss making companies. Whereas a perusal of year wise details of operating margin ratio of both the entities at page 293 of the paper book would show that out of 7 years ( from 1999-00 to 2005-06) the aforesaid companies have earned profits in 4 years. Up to the period relevant to the assessment year 2004-05 both the comparables have losses in 2 years only. To be considered as a consistent loss making company, the company should have incurred losses in 3 c .....

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s is not appropriate. A comparable should not be rejected merely on the ground that it has loss in a particular year. In support of his submissions, the ld. AR placed reliance on the following judgments : i. Joy Alukkas India Pvt. Ltd. Vs. ACIT in ITA No. 230 of 2013 decided on 20-01-2014 (Kerala HC); ii. Chryscapital Investment Advisors (India) (P.) Ltd. Vs. DCIT, 56 taxmann.com 417 (Delhi); iii. Cummins Turbo Technologies Limited Vs. DDIT (International Taxation) in ITA No. 118/PN/2011 decided .....

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having prior information regarding its future capacity unitization. During the first appellate proceedings the assessee was given opportunity to explain whether similar conditions were faced by the comparable companies. The assessee was further asked to give the details for normal capacity rate of the industries in which the assessee company is operating and as to how under utilization of the capacity is arrived at with respect to comparable companies. The assessee vide letter dated 01-12-2009 .....

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The ld. DR submitted that as far as ground no. 4 raised in the appeal with regard to benefit of safe harbour ± 5% is concerned the provisions of section 92C(2) have been amended by the Finance Act, 2012 with retrospective effect from 01-04-2002. Therefore, the assessee cannot claim the benefit of ± 5%, if the difference between the ALP determined by the TPO and actual price charged is beyond the ± 5% margin. 6. The ld. AR of the assessee controverting the submissions made o .....

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ecisions on which the ld. AR of the assessee has placed reliance to support his submissions. The assessee in its appeal has raised 6 grounds. Ground Nos. 1, 5 and 6 are general in nature. Hence, require no adjudication. Thus, the effective grounds raised in the appeal are 2, 3 and 4 only. 8. In ground no. 2 the assessee has assailed the findings of Commissioner of Income Tax (Appeals) in upholding the order of Assessing Officer in rejecting functional (capacity utilization) adjustment. The conte .....

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Documentation business of the assessee. The assessee has given working of under utilization of the capacity and manpower for documentation business at page 181 of the paper book. The relevant extract of the same is reproduced here-in-under: Sr. No. Particulars Number I Under-absorption of Overheads Installed capacity - Jobs per day 413 Actual Jobs per day 294 Under-utilization of working facilities 119 % Under-utilisation of working facilities - 29% I Under-utilization of Manpower Average Number .....

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It is presumed that the orders/business are assured because the entire capacity created is for the purpose of business of the holding AE. The under utilization of the capacity can only be possible if the holding AE is not performing well. The fact that the assessee has increased the working capacity during the year has not been examined by the authorities below. The TPO and the Commissioner of Income Tax (Appeals) rejected the contentions of the assessee merely on the ground that the assessee i .....

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ture business demands can be predicted with accuracy by using modern business management tools. If that would be the case, no business venture would fail. The future is uncertain, market forces play a vital role in providing buoyancy to new business ventures. The claim of the assessee can be rejected if the assertions made by the assessee are found to be incorrect. The Tribunal in various cases has granted under/low capacity utilization adjustments. 9. The Bangalore Bench of the Tribunal in the .....

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erating margin on cost would be 27.46%. He submitted that the learned TPO has rejected the adjustments on the ground that comparables have similar problem as they have idle bench strength. He submitted that the adjustments sought was for under utilization of infrastructure while in the case of comparables, it is the case of idle bench strength. He submitted that infrastructure certain fixed costs attached to it which would affect the operating margin of the assessee considerably. 15.1 In support .....

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199-200 of paper book-2, wherein the TPO has observed that the average under utilization of manpower in ITES industry is 20% as per information available in the public domain. The adjustment to the extent of difference is being allowed. He submitted that when the under utilization of manpower is allowed, similar adjustment for under utilization of infrastructure also has to be allowed. 10. The Pune Bench of the Tribunal in the case of Tasty Bite Eatables Limited Vs. ACIT (supra) while dealing wi .....

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n in an elaborate manner bifurcated the issue in two parts i.e. capacity adjustment, allowable in whose hands and how to compute capacity adjustment under TNMM. The relevant extract of the order of Tribunal reads as under: 8. We have heard the rival submissions and perused the relevant material on record. Before embarking upon the question of allowability and extent of capacity adjustment under the TNMM, we want to make it clear that the assessee reduced its operating costs by considering its ca .....

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e authorities below or comparables and second, how to compute capacity utilization adjustment under the TNMM. We will deal with these aspects one by one. i. Capacity adjustment should be allowed in whose hands? 9.1. It has been noticed above that the assessee claimed idle capacity adjustment by reducing its own operating costs. It is further observed that the authorities below have reduced the amount of adjustment by excluding certain costs from the ambit of the costs qualifying for adjustment. .....

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ethod, by which,- (i) the net profit margin realised by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base ; (ii) the net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to th .....

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blished to be the same as the net profit margin referred to in sub-clause (iii) ; (v) the net profit margin thus established is then taken into account to arrive at an arm s length price in relation to the international transaction. 9.2. Sub-clause (i) in the process of determination of the ALP under the TNMM talks of the computation of net operating profit margin realized by the assessee from an international transaction. Sub-clause (ii) is the computation of net operating profit margin realize .....

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unt of net profit margin in the open market. It is this adjusted net profit margin of the unrelated transactions or of the comparable companies, as determined under sub-clause (iii), which is used for the purposes of making comparison with the net profit margin realized by the assessee from its international transaction as per sub-clause (i). 9.3. Sub-rule (2) of Rule 10B provides that the comparability of an international transaction with an uncontrolled transaction shall be judged with referen .....

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of comparable companies calls for adjustment in such a manner so as to bring both the international transaction and comparable cases at the same pedestal. In other words, if there are no differences in these two, then the average of the net operating profit margin of the comparable companies becomes a benchmark. However, in case there are some differences between the comparables and the assessee, then the effect of such differences should be ironed out by making suitable adjustment to the opera .....

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her way around to adjust the profit margin of the assessee. In other words, the net operating profit margin realized by the assessee from its international transaction is to be computed as such, without adjusting it on account of differences with the comparable uncontrolled transactions. The adjustment, if any, is required to be made only in the profit margins of the comparables. 9.4. Reverting to the facts of the instant case, we find that the authorities below have adjusted the operating costs .....

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n allowing adjustment, which is not in consonance with law, we cannot approve the same. The impugned order is set aside and the matter is restored to the file of the TPO/AO for giving effect to the amount of idle capacity adjustment in the operating profit of the comparables and not the assessee. ii. How to compute capacity utilization adjustment under TNMM: - 10.1. Under the TNMM, the ALP of an international transaction is determined by computing and comparing the percentage of operating profit .....

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comparables. There can be no difficulty in working out these percentages. The second step is to give effect (positive or negative) to the difference in the percentage of capacity utilizations of the assessee vis-à-vis comparables, one by one, in the operating profit of comparables by adjusting their respective operating costs. Operating costs can be either fixed or variable or semi-variable. One needs to split semi-variable costs into the fixed part and variable part. In so far as the var .....

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ple. Suppose the fixed costs incurred by a comparable (say, A) are ₹ 100 and it has capacity utilization of 50% as against the capacity utilization of 25% by the assessee. The above percentages show that the assessee has incurred full fixed costs with 25% of the utilization of its capacity, as against A incurring full fixed costs with 50% of its capacity utilization. This divulges that the assessee has incurred relatively more fixed costs and A has incurred lower costs. In order to make an .....

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rred at ₹ 100, it would mean that the fixed costs incurred by the assessee and A are at the same capacity utilization. There can be converse situation as well. Suppose the fixed costs incurred by a comparable (say, B) are ₹ 100 and it has capacity utilization of 25% as against the capacity utilization of 50% by the assessee. The above percentages show that the assessee has incurred full fixed costs at 50% of the utilization of its capacity, as against B incurring full fixed costs at .....

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he fixed costs at ₹ 50 with the actually incurred at ₹ 100, it would mean that the fixed costs incurred by the assessee and B are at the same capacity utilization level. 10.3. Turning to the facts of the instant case, we find that both the TPO as well as the ld. CIT(A) have proceeded on a wrong premise not only by allowing capacity utilization adjustment in the assessee s profit, which is contrary to the legal position as discussed above, but also by considering all the comparables a .....

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of financials of all the comparable companies, it is not possible at our end to work out the amount of capacity adjustment in the manner discussed above. Ergo, we set aside the impugned order and direct the TPO/AO to work out the amount of capacity utilization adjustment afresh in terms of our above observations. Needless to say, the assessee will be allowed a reasonable opportunity of hearing in such fresh proceedings. 12. Thus, in view of the decisions of the Tribunal discussed above, it is e .....

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ee has impugned the findings of Commissioner of Income Tax (Appeals) in rejecting two comparable companies on the ground that they are loss making entities. The assessee had selected 7 comparables with the following operating margin ratio : Comparable Company Operating Margin Ratio Ace software Exports Limited 16.97% C S Software Enterprise Limited 10.4% F I Sofex Limited (120.13)% Fortune Informatics Limited (47.58)% Federal Technologies Limited 8.47% K L G Systel Limited 9.74% Zigma Software L .....

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01-02 (20.83) 3.74 2000-01 6.45 4.35 1999-00 48.70 29.11 13.2 The contention of the assessee is that the said companies cannot be rejected merely on the ground that in a particular year, the companies have incurred losses. We find merit in the contention of the ld. AR of the assessee. A comparable can be rejected only if it is a consistent loss making company and the consistent loss making company is one which sustains losses in the three consecutive financial years. The Pune Bench of the Tribun .....

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of Capital Trust and found that in the foreign consultancy segment with which the Bench was concerned in the year 2004-05, it had operative profit / operative cost at 27.25%. Since the nature of services rendered by comparable were exactly on similar lines as that of the assessee, though, during the year, it was in the loss could not be disqualified as nonlegitimate comparable. The Tribunal drew strength from Brigade Global services (supra) for reaching this conclusion and held that the assessee .....

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attention qua the conditions prescribed in clause (a) to (d) of Rule 10B(2) of IT Rules, 1962 for an ultimate judgment of comparability of impugned transaction. So, the persistent loss making means continuous loss making for more than 3 years but in the case before us i.e. Stovec has earned a margin of 2.39% in comparable segment in F.Y. 2003-04. Hence, it could not be considered as loss making, so the same should be excluded for computing operative margin of comparable companies for arriving a .....

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e Hon'ble Delhi High Court in the case of CIT Vs. Mentor Graphics (Noida) (P.) Ltd. reported as 354 ITR 586 concluded as under: 44. a. The mere fact that an entity makes high/extremely high profits/losses doesnot, ipso facto, lead to its exclusion from the list of comparables for the purposes of determination of ALP. In such circumstances, an enquiry under Rule 108(3) ought to be carried out, to determine as to whether the material differences between the assessee and the said entity can be .....

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er: 14. We find that in respect of the selection of the comparables, the Tribunal has taken the consistent stand that as the super profit companies should not be included, the same way, super loss making companies should also be excluded. Though we agree with the TPO that some of the comparables for the purpose of PLI adopted by the assessee are showing the loss, but the burden is on the TPO to prove where those companies are consistently loss making companies. Moreover, except unsupported reaso .....

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ing companies has not been ascertained by the TPO before rejecting the same. A company is said to be bad comparable if it is a consistent loss making entity. Accordingly, we are of the opinion that this issue needs a revisit to the Assessing Officer. The Assessing Officer after considering the submissions of the assessee and documents on record shall decide the issue afresh in the light of the decisions discussed above. Accordingly, this ground of appeal of the assessee is allowed for statistica .....

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