2014 (12) TMI 894 - AT - Income Tax

Adjustment for difference in depreciation rates Whether variation in the rates of depreciation can be considered as a relevant factor necessitating adjustment in the operating profit margin of the comparables Held that - The assessee charged depreciation in its Profit & Loss account at the SLM rates higher than those provided in the Schedule XIV to the Companies Act - neither any adjustment can be made for a simplicitor higher/lower amount of depreciation in itself or as a percentage of the total operating expenses nor an otherwise comparable company ceases to be comparable because of the above factors - However, an adjustment is called for when there is a difference in the rates of depreciation on similar types of assets under similar method of charging depreciation - there is no provision for determining the ALP of an international transaction for more than one year in a consolidated manner. Unlike the hitherto determination of undisclosed income for the block period as provided under Chapter XIV-B of the Act, as opposed to year-to year basis, there is no such provision for determining the ALP of an international transaction for more than one year by considering a few years as one unit during which an asset is put to use - Not only is this exercise impermissible under the law, but is also impractical of application. Various assets will have varying useful life spans due to different rates of depreciation and their useful life will not terminate at one common point of time, so as to facilitate the making of adjustment at such point of time - the method of charging depreciation, both by the assessee and its comparables, is by and large the same that is SLM - The assessee is seeking adjustment only due to higher rates of depreciation charged by it under SLM with the lower rates of depreciation charged by four comparable companies, other than Mapro Industries Ltd. and Karvy Consultants Ltd. - the operating profit margins of these four comparable companies should be recomputed by the TPO/AO in line with the rates of depreciation charged by the assessee under SLM. The amount of depreciation of the four comparable companies on their assets shall also be recomputed under the SLM alone as per the rates at which the assessee has provided depreciation - In doing so, if the comparable companies have charged depreciation at a lower rate in comparison with the assessee, then suitable increase should be made to their amount of depreciation and if the comparables have charged depreciation at a higher rate in comparison with the assessee on some of the assets, then suitable reduction should be made in the amount of their depreciation - one of these four companies, namely, Nucleus Netsoft and GIS India Ltd has charged depreciation on all its assets under SLM except for Computers, on which it provided depreciation on written down value basis - The TPO should see if he can correctly deduce the amount of depreciation, on the basis of data available, for the year on Computers also under SLM - If due to one reason or the other, such precise calculation is not possible, then no adjustment should be carried out in the calculation of the operating profits of this company, even on other items of assets - since neither the assessee nor the Revenue seek the exclusion of this company from the list of comparables, it cannot be done suo motu - if the assessee as well as the comparable companies are using the SLM and there is a difference in the rates of depreciation charged by them, then there is a need to make suitable adjustment to the profits of the comparables. Risk adjustment Held that - The assessee is responsible for effective utilization of its resources and its foreign AE did not assure the assessee of a minimum level of utilization - the assessee bears excess capacity or utilization risk in respect of the provision of services - the assessee is responsible for effective utilization of its resources and there is no assurance of the volume of business generating from its AE - If there is no/less business, the assessee will continue to incur costs for which there will be no compensation from the AE - the assessee also bears foreign exchange fluctuation risk because it incurs expenses in Indian rupees, whereas its revenues are earned in US dollars - the assessee bears substantial business risks with regard to its operations - the assessee is hybrid of a captive unit combined with the attributes of risk taking entrepreneurial unit - the assessee has also undertaken business/capacity/foreign exchange fluctuation risks, the contention that the assessee did not bear any/minimal risks, does not merit acceptance - The other part of the argument about the comparables undertaking much more risks, is not substantiated with any worthwhile evidence - any risk adjustment in the operating profit margins of the comparables on this score cannot be accepted. Allowability of treansfer pricing adjustment Group Suffering losses Held that - Some of the associated enterprises of the overall group may suffer loss due to their own inefficiencies and wrong business decisions and the consequences of such wrong decisions taken by them cannot be allowed to affect the ALP of the international transaction undertaken by the assessee in India - the overall loss incurred by group companies as a whole can never be a criteria to desist from making any TP adjustment, which is otherwise called for as per the statutory provisions under the Act. Exclusion of Fortune Infotech Ltd from the list of comparables Held that - There can be no fetters on the assessee in claiming before the authorities that a particular company was inadvertently included in the list of comparables - mere making of a claim of incomparability does not automatically lead to exclusion - If a company, which is actually not comparable, but was inadvertently included by the assessee in the list of comparables, the same is liable to be excluded - the exclusion of the otherwise comparable company from the list of comparables cannot be allowed on the simple ground of higher profit earned by it during the extant year. First proviso to section 92C(2) provides that where more than one price is determined by the most appropriate method, the ALP shall be taken to be the arithmetical mean of such prices - It transpires that the Indian legislation talks of considering all the comparables and then finding out the arithmetic mean of the price/profit of such comparables - Fortune Infotech Ltd. is a comparable company warranting its inclusion in the list of comparables. Provision of expenses disallowed Held that - The assessee is constantly making provision for expenses on year-to-year basis on the estimate of reasonable expenses incurred but the bills not received up to the year-ending - When in the subsequent year, the bills are received, such provision is reversed - If the actual amount of expenses for which the provision was made falls short of such provision, then deduction is claimed for the excess expenditure and in the converse situation, the earlier excess provision created is reversed in the succeeding year - the expenses are basically in the nature of professional fee, telephone expenses, communication expenses and consultation, etc. - the deletion of the addition sustained in the first appeal is allowed decided partly in favour of assessee.

Summary

Issues Involved:
1. Adjustment for difference in depreciation rates
2. Risk adjustment
3. Transfer pricing adjustment due to group suffering loss
4. Exclusion of Fortune Infotech Ltd. from the list of comparables
5. Disallowance of provision for expenses
6. Rent equalization reserve

Detailed Analysis:

I. Adjustment for Difference in Depreciation Rates:
The first issue concerns the assessee's claim for an adjustment in the operating profit margins due to higher depreciation rates charged in its Profit & Loss account compared to the stipulated rates in Schedule XIV of the Indian Companies Act, 1956. The assessee charged depreciation on Straight Line Method (SLM) at higher rates, while the comparable companies adhered to the prescribed rates.

The Tribunal noted that the assessee's contention was not raised before the TPO or CIT(A) but was accepted by the Dispute Resolution Panel (DRP) for other assessment years. The Tribunal emphasized the need to verify the factual position of the depreciation rates charged by the assessee and its comparables. It was observed that the assessee charged higher depreciation rates, which necessitated adjustment to ensure comparability. The Tribunal directed the TPO/AO to recompute the operating profit margins of the comparable companies by adjusting their depreciation rates to match those charged by the assessee.

II. Risk Adjustment:
The assessee argued for a risk adjustment, claiming it undertook minimal risks compared to the comparables. The Tribunal examined the Transfer Pricing (TP) study report and found that the assessee bore significant risks, including utilization risk, foreign exchange fluctuation risk, and business risk. Consequently, the Tribunal concluded that the assessee was not a captive unit with minimal risks but a hybrid entity assuming substantial risks. The Tribunal rejected the request for risk adjustment due to the lack of substantial evidence indicating the level of risks undertaken by the comparables.

III. Transfer Pricing Adjustment Due to Group Suffering Loss:
The assessee contended that the transfer pricing adjustment should be restricted to the overall profit at the group level, citing the group's overall loss. The Tribunal rejected this argument, emphasizing that Chapter X of the Act requires computation of income from international transactions based on the arm's length price (ALP) of each transaction, not the overall profitability of the group. The Tribunal held that the overall loss incurred by the group cannot be a criterion to avoid TP adjustment.

IV. Exclusion of Fortune Infotech Ltd. from the List of Comparables:
The assessee sought the exclusion of Fortune Infotech Ltd. from the list of comparables, arguing it was functionally incomparable and had abnormal profits for the year. The Tribunal examined the financials and functional profile of Fortune Infotech Ltd. and found no abnormal circumstances for the year in question. The Tribunal held that higher profit margins alone do not justify exclusion and upheld the inclusion of Fortune Infotech Ltd. in the list of comparables.

V. Disallowance of Provision for Expenses:
The assessee challenged the disallowance of a provision for expenses amounting to Rs. 32,08,612/-. The Tribunal noted that the assessee consistently made provisions for expenses on a year-to-year basis, which were reversed in subsequent years upon receipt of invoices. The Tribunal emphasized the principle of consistency and the mercantile system of accounting, ordering the deletion of the sustained addition.

VI. Rent Equalization Reserve:
The Revenue's appeal contested the deletion of an addition of Rs. 40,50,472/-, being rent equalization reserve included in the provision for expenses. The Tribunal referred to judicial precedents, including the judgment of the Hon'ble jurisdictional High Court in CIT vs. Virtual Soft Systems Ltd., which held that lease equalization charges debited to the Profit & Loss Account cannot be disallowed. The Tribunal upheld the CIT(A)'s decision to delete the addition.

Conclusion:
The Tribunal partly allowed the assessee's appeal and dismissed the Revenue's appeal, directing the TPO/AO to make fresh determinations in accordance with the Tribunal's observations and conclusions.