2015 (3) TMI 235 - AT - Income Tax

Addition on account of arm s length price (ALP) adjustment - Held that - CIT(A) has granted the impugned relief by making adjustments, on account of capacity underutilization, in the results shown by the tested party and thus computing hypothetical financial results which the tested party would have achieved in perfect conditions. Such an exercise, in our humble understanding of law, is impermissible. As is the undisputed legal position, such comparability adjustments can only be made in the comparables and not the tested party itself. It is specifically provided in Rule 10B (1)(e)(iii) that adjustments for variations, which could materially affect the amount of net profit margin in the open market in comparable uncontrolled transactions, are to be made in respect of net profits realized by the comparable transactions or enterprises. Learned CIT(A) was thus clearly in error in proceeding to make capacity underutilization adjustments in the profits earned by the assessee. As the assessee does not have the liberty to work for any other customer, and is wholly dependent on its AE for productive use of its capacity to work, the AE should normally make good any losses to the captive unit caused by its not being able to make use of the available capacity. In the case before this, the AE has indeed given some financial support to the assessee which has been reduced from the ALP adjustment figure, and the business rationale of AE s extending financial support to the assesse is thus not in doubt. However, there is nothing on record to show how this financial support has been computed and is on what ground, and on what basis, this financial support is given. The reason for underutilized capacity and the facts regarding financial support extended to the assessee are not clear from the material on record. Learned CIT(A) has granted the impugned relief merely by making capacity underutilization adjustments to the profits achieved by the tested party, but then such an approach, as we have noted earlier, is wholly unsustainable in law. - Matter remanded back - Decided in favour of Revenue.

Summary

Issues:
Challenge to deletion of arm's length price adjustment under section 92CA (3) of the Income Tax Act, 1961 for the assessment year 2005-06.

Analysis:
The appellant, an Assessing Officer, contested the deletion of a substantial arm's length price (ALP) adjustment by the learned Commissioner (Appeals) related to international transactions reported by the assessee. The appellant argued that the adjustment made by the Transfer Pricing Officer (TPO) was valid due to underutilizations of various costs. However, the CIT(A) upheld the assessee's grievance by considering capacity underutilization and made adjustments, leading to a higher margin compared to industry standards set by the TPO.

The Assessing Officer challenged the relief granted by the CIT(A), contending that adjustments for capacity underutilization should only be made in comparables, not the tested party itself. The tribunal noted that such adjustments are impermissible in the tested party's profits as per Rule 10B (1)(e)(iii). In the case of a captive service unit like the assessee, capacity underutilization may not be relevant unless the underutilized capacity cannot be offered to the associated enterprise (AE). The tribunal emphasized the need for clarity on the reasons for underutilization and the basis for financial support provided by the AE. While acknowledging the financial support received by the assessee, the tribunal found the CIT(A)'s approach of making capacity underutilization adjustments unsustainable in law.

Ultimately, the tribunal decided to vacate the CIT(A)'s order and directed a fresh decision after providing the assessee with a hearing opportunity, ensuring compliance with the law and issuing a detailed order. The appeal was allowed for statistical purposes, and the decision was pronounced on October 13, 2014.