2010 (2) TMI 1170 - AT - Income Tax

Rectification of mistake u/s 154 - TP Adjustment - Determination of Arms Length Price - value of international transaction - whether TPO s order is erroneous because he has applied the net profit margin of 7.25% on the gross sales and followed a complicated procedure to arrive at the amount of adjustment? HELD THAT - We partially agree with the submissions of the ld. counsel for the assessee that original TPO s order is definitely erroneous because he has applied the net profit margin of 7.25% on the gross sales and followed a complicated procedure to arrive at the amount of adjustment. In simple terms if the sales to Associated Enterprises is taken at ₹ 25 crores and straight way 7.25% margin is applied then approximately total margin would be ₹ 1.81 crores, whereas adjustment has been made at ₹ 2,57,26,138/-. At the same time we are unable to agree with the order of ld. CIT(A) that no adjustment could have been made. Admittedly, the assessee has no objection that if TNMM was followed and even no objection was raised to the average profit rate of 7.25%. However, as argued that this rate should be taken as only operating profiting which is not correct because TNMM in Rule 10B of Income tax Rules refers to only net profit and, therefore, there is no scope for reducing interest or any other overheads. Here also TPO has at top of the chart where average rate was calculated at page 2 of his order refers to OP/TC%. Therefore, it is not clear whether this margin is net profit or not. Similarly how the cost etc. was distributed by ld. CIT(A) is not clear because detailed figures are not available. Therefore, in the interest of justice we set aside the order of ld. CIT(A) and remit the matter back to AO with a direction to follow TNMM by working out the average net profit. Further, the adjustment should be worked out on a very simple basis by reducing the net profit declared by the assessee from the gross sales and then divide the same in the controlled and uncontrolled sale and apply the net profit rate. Appeals are allowed for statistical purposes.

Issues Involved:
1. Determination of Arm's Length Price (ALP) for international transactions.
2. Appropriate method for calculating ALP (Cost Plus Method vs. Transactional Net Margin Method - TNMM).
3. Rectification application under section 154 of the Income-tax Act.
4. Calculation errors and adjustments in ALP determination by Transfer Pricing Officer (TPO).

Detailed Analysis:

1. Determination of Arm's Length Price (ALP) for International Transactions:
The primary issue in the appeals was the determination of the ALP for international transactions undertaken by the assessee. The TPO initially rejected the Cost Plus Method adopted by the assessee and instead applied the TNMM method, leading to an adjustment of Rs. 2,57,26,138/-. The TPO's calculation was based on a set of comparable companies, resulting in an average profit margin of 7.25%.

2. Appropriate Method for Calculating ALP:
The assessee initially used the Cost Plus Method, claiming a G.P margin of 16.95% from unrelated parties and 19.37% from related parties, suggesting transactions were at ALP. The TPO rejected this method due to a lack of detailed margin calculations and functional differences between third-party and related-party transactions. Consequently, the TPO issued a show-cause notice proposing the TNMM method, which the assessee eventually accepted.

3. Rectification Application under Section 154:
The assessee filed a rectification application under section 154, arguing that the TPO's adjustment was incorrectly applied to total sales, including uncontrolled sales. The assessee contended that adjustments should only apply to controlled sales, suggesting a revised calculation that resulted in a lower adjustment of Rs. 61,18,362/-. The TPO rejected this application, maintaining that the original adjustment was correctly calculated.

4. Calculation Errors and Adjustments in ALP Determination:
The CIT(A) observed that the TPO's adjustment was excessive as it applied the 7.25% profit margin to the total cost of both related and unrelated transactions, which was not permissible. The CIT(A) accepted the assessee's revised calculation, concluding that no adjustment was necessary as the actual sales were above the 95% Arm's Length Value of sales to AE.

The CIT(A) stated:
> "The T.P.O was first required to obtain figures of sales and costs in respect of appellant's international transactions with the AEs. Then as per TNMM, the arm's length profit margin of 7.25% should have been applied to such cost to determine arm's length value of sales and accordingly, the adjustment was required to be made."

However, the appellate tribunal found issues with both the TPO's and CIT(A)'s calculations. The tribunal noted that the TPO's method was erroneous as it applied the net profit margin to gross sales, leading to an inflated adjustment. The tribunal also found the CIT(A)'s methodology unclear due to a lack of detailed figures.

The tribunal concluded:
> "We set aside the order of ld. CIT(A) and remit the matter back to the file of AO with a direction to follow TNMM by working out the average net profit. Further, the adjustment should be worked out on a very simple basis by reducing the net profit declared by the assessee from the gross sales and then divide the same in the controlled and uncontrolled sale and apply the net profit rate."

Conclusion:
The tribunal allowed the appeals for statistical purposes, directing the Assessing Officer (AO) to re-calculate the ALP using the TNMM method, ensuring a clear and simple calculation process. The assessee should be given an adequate opportunity for a hearing during this process.

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