2014 (4) TMI 614 - AT - Income Tax

Deletion made on account to international transaction with AE Determination of method Held that - The method specifies in Clause (ii) that the relative contribution made by each of associated enterprise should be evaluated on the basis of FAK analysis and on the basis of reliable external data - bench marking by selection of comparables is mandatory under this Method - Relying upon Aztec Software & Technology Services Ltd. v. Asstt. CIT, Bangalore (SB) 2007 (7) TMI 50 - ITAT BANGALORE - The profits need to be split among the AEs on the basis of reliable external market data, which indicate how unrelated parties have split the profits in similar circumstances - For practical application, bench marking with reliable external market data is to be done, in case of residual profit split method, at the first stage, where the combined net profits are partially allocated to each enterprise so as to provide it with an appropriate base returns keeping in view the nature of the transaction - The residual profits may be split as per relative contribution of the Associated Enterprise - splitting of residual profits, no bench marking is necessary, as it is not practicable. The transfer pricing report furnished by the assessee is not in accordance with rules prescribed in this regard - The PSM has not been correctly applied as per law - No bench marking has been done thus, it cannot be approved - the most appropriate method in this type of function/transaction would be profit split method only - the relevant years were the formative years, when transfer pricing was introduced and the law was developing thus, the matter is remitted back to the AO for fresh adjudication Decided in favour of Revenue.

Summary

Issues Involved:
1. Deletion of addition made by the Assessing Officer (AO) on account of international transactions with associate enterprises.
2. Determination of the most appropriate method for transfer pricing adjustment.

Issue-wise Detailed Analysis:

1. Deletion of Addition Made by the AO:
The Revenue appealed against the order of the Commissioner of Income Tax (Appeals), who had deleted the addition of Rs. 43,69,441/- made by the AO. The AO had made this addition based on the Transfer Pricing Officer's (TPO) suggestion, which was due to a difference in the arm's length price of international transactions with associated enterprises. The TPO disagreed with the appellant's use of the Profit Split Method (PSM) and instead applied the Transactional Net Margin Method (TNMM), leading to the adjustment.

2. Determination of the Most Appropriate Method for Transfer Pricing Adjustment:
The core issue revolved around the selection of the most appropriate method for determining the arm's length price of international transactions. The appellant used the Profit Split Method (PSM) for cost collection received and paid, rejecting the TNMM due to unsatisfactory search results and lack of comparable companies in the public domain. The TPO, however, argued that sufficient information was unavailable to validate the 50% profit-sharing arrangement and chose TNMM as the most appropriate method. The TPO compared the appellant's net operating margin of 2.56% with an average margin of 7.17% from seven comparable companies, resulting in the adjustment.

Transfer Pricing Report and Order:
The appellant, a subsidiary providing freight forwarding services, used PSM based on a profit-sharing ratio of 50% for inbound and outbound shipments. The TPO, however, found TNMM more suitable, citing guidelines from Rule 10C and public databases to identify comparables. The TPO's analysis led to the conclusion that the appellant's operating margin was significantly lower than the comparables, justifying the adjustment.

Arguments and Contentions:
The appellant's counsel argued that PSM was the most appropriate method and that the requisite documents were submitted during remand proceedings. They contended that the AO's comparables were selected without proper application of mind and that the AO could not substitute the most appropriate method. The counsel also highlighted that the department accepted the appellant's PSM in subsequent assessment years, advocating for consistency.

Tribunal's Findings:
The Tribunal analyzed the rules and found that PSM was indeed the most appropriate method for the appellant's transactions but noted that the method was not correctly applied as per law, particularly due to the lack of benchmarking. The Tribunal also disapproved of the TPO's application of TNMM at the entity level, referencing the Special Bench's decision in the L.G. Electronics case, which emphasized transaction-level comparison and benchmarking.

Conclusion and Remand:
The Tribunal set aside the issue to the AO for fresh adjudication, allowing the appellant to file a new transfer pricing study with comparables in accordance with the law. The AO/TPO was instructed to consider this fresh study and adjudicate the matter de novo. The appeal of the Revenue was allowed for statistical purposes, and the order was pronounced in the Open Court on 31st December 2013.