2011 (9) TMI 562 - AT - Income Tax

Transfer Pricing - Arm Length Price - Diamonds Imported on free of cost of basis - ad hoc adjustment - AO contended Rate of processing the diamonds remained same whereas the cost of processing has increased substantially - Assessee replied loss on a/c of foreign exchange fluctuations, Depreciation - Held That - . The action of the TPO in making substantial adjustment on the basis of labour cost to revenue ratio of the previous year without providing any independent comparable case where revenue increase was based on such ratio, in our opinion, is not proper and unjustified. Merely, because the personnel cost has gone up, the same in our opinion, cannot be the basis for assuming that the processing income also should go up. Decided against revenue. Adjustment on the basis of labour charges - the main reason for adjustment of the ALP is that although there is no significant change in the capacity utilization during the impugned assessment year as compared to A.Y. 2004-05, the percentage of labour charges to processing income has gone up from 39.16% to 55.41%. According to the TPO, the assessee has not been able to substantiate that the labour is of a fixed nature only. Further, according to the TPO, the AE should have compensated the assessee for excess labour due to its inability to give substantial work to it. - held that - When regular employees are working with an assessee, he cannot terminate their services because of lesser capacity utilization during the year. The utilization of capacity during the year depends on various factors, the main factor being receiving orders from overseas and other clients. Further, the orders also should be acceptable to the assessee considering the profitability. - the adjustment of Rs. 3,25,92,361/- is uncalled for and accordingly directed to be deleted. - Decided in favor of assessee.

Summary

Issues Involved:
1. Adjustment to Arms Length Price (ALP) under Section 92CA(3) for international transactions.
2. Determination of ALP for subsequent assessment year.
3. Treatment of interest income as income from other sources.

Issue-Wise Detailed Analysis:

1. Adjustment to Arms Length Price (ALP) under Section 92CA(3) for international transactions:

The Revenue challenged the deletion of an adjustment made to the ALP of Rs. 4.25 crores by the CIT(A). The TPO's adjustment was based on the increase in personnel costs without a corresponding increase in processing income. The TPO had assumed that the increase in labor costs should automatically lead to increased processing income and made an ad hoc adjustment. The CIT(A) found this approach flawed, noting that the TPO failed to provide any independent comparable case to justify the adjustment. The CIT(A) emphasized that business operations do not always follow a simple arithmetic logic where an increase in costs leads to a proportional increase in revenue. The CIT(A) also noted that the assessee had provided valid reasons for the fall in profits, such as a reduction in revenue, an increase in overall expenses, and increased depreciation. These reasons were neither rebutted nor accepted by the TPO. The CIT(A) concluded that the assessee's pricing was at arm's length and deleted the adjustment.

2. Determination of ALP for subsequent assessment year:

For the subsequent assessment year, the TPO made an adjustment of Rs. 3.25 crores to the ALP, arguing that the labor cost to processing income ratio had increased significantly. The TPO claimed that the assessee had not justified the lower margins and had not increased its processing rates despite higher labor costs. The assessee argued that the labor costs were fixed and that the lower capacity utilization led to higher labor costs relative to revenue. The assessee also provided evidence that the per-unit rate charged was higher than the market rate. The Tribunal found that the TPO's adjustment was unjustified, noting that the increase in labor costs was due to annual increments and that the capacity utilization depended on various factors. The Tribunal also noted that the adjustment made by the TPO in the previous year was deleted by the CIT(A) and upheld by the Tribunal. Therefore, the Tribunal held that the adjustment for the current year was uncalled for and directed its deletion.

3. Treatment of interest income as income from other sources:

The assessee challenged the AO's treatment of interest income as income from other sources, thereby denying the benefit of exemption under Section 10A. However, the Tribunal noted that these grounds did not emanate from the order of the DRP against which the appeal was filed. The assessee's counsel did not seriously press these grounds during the hearing. Consequently, these grounds were dismissed.

Conclusion:

The Tribunal upheld the CIT(A)'s deletion of the Rs. 4.25 crores adjustment for the assessment year 2005-06 and directed the deletion of the Rs. 3.25 crores adjustment for the assessment year 2006-07. The Tribunal dismissed the grounds related to the treatment of interest income as income from other sources. The appeal by the Revenue was dismissed, and the appeal by the assessee was partly allowed.