2015 (4) TMI 180 - AT - Income Tax

TPA - Notional interest charged on receivables outstanding beyond 180 days - AO/DRP enhancing the income of the assessee - Held that - A working adjustment appropriately takes into account the outstanding receivable. Therefore, the assessee has undertaken a working capital adjustment to reflect these differences by adjusting for differences in working capital and thereby, profitability of each comparable company. Accordingly, while calculating the working capital adjusted, operating margin on costs of the comparable companies, the impact of outstanding receivables on the profitability has been taken into account. If the pricing/ profitability of the assessee are more than the working capital adjusted margin of the comparables, then additional imputation of interest on the outstanding receivables is not warranted. The differential impact of working capital of the vis-a-vis its comparables has already been factored in the pricing/profitability of the assessee which is more than that working capital adjusted margin of the comparables. Hence, any further adjustment to the margins of the assessee on the pretext of outstanding receivables is unwarranted and wholly unjustified. It is clear that assessee had earned significantly higher margin than the comparable companies (which have been accepted by the TPO) which more than compensates for the credit period extended to the AEs. Thus, the approach by the assessee of aggregating the international transactions pertaining to sale of goods to AE and receivables arising from such transactions which is undoubtedly inextricable connected is in accordance with established TP principles as well as ratio laid down by the Hon ble jurisdictional High Court in the case of Sony Ericson Mobile Communication India Pvt. Ltd. (2015 (3) TMI 580 - DELHI HIGH COURT). - Decided in favour of assessee.

Summary

Issues Involved
1. Justification of enhancing the income of the assessee by Rs. 93,69,275/- due to notional interest on receivables outstanding beyond 180 days.

Detailed Analysis

Justification of Enhancing Income by Notional Interest on Receivables
The solitary issue in this appeal is whether the AO/DRP is justified in enhancing the income of the assessee by Rs. 93,69,275/- on account of notional interest charged on receivables outstanding beyond 180 days.

Facts:
The assessee, a company manufacturing and marketing pharmaceutical products, engaged in exporting to its overseas associated enterprise (AE) and third parties, benchmarked its international transactions using the Transactional Net Margin Method (TNMM) as the Most Appropriate Method (MAM). The segmental profitability from its manufacturing and trading segments was compared with margins earned by comparable companies. The operating profit margins of the assessee in both segments were higher than those of the comparables, thus considered at arm's length price.

Assessment Proceedings:
During the assessment proceeding, the TPO accepted the international transactions at arm's length price but imputed a notional interest based on SBI Prime Lending rate + 300 basis points (14.88%) on receivables outstanding beyond 180 days. This resulted in a transfer pricing adjustment of Rs. 1,57,54,943/- which was later revised to Rs. 93,69,275/- by applying the SBI base rate plus 150 basis points, as directed by the DRP.

Assessee's Arguments:
1. Working Capital Adjustment: The assessee argued that a working capital adjustment already accounts for the impact of outstanding receivables on profitability. This adjustment should bring parity between the working capital investment of the assessee and comparables.
2. Aggregation of Transactions: The principle of aggregation should apply, combining functionally similar transactions to determine the arm's length price for a number of transactions taken together.
3. No Interest to Non-Group Companies: No interest was charged on overdue balances from unrelated third parties, and the AE was a key customer, contributing 88% of the total turnover.
4. Re-characterization of Receivables: The TPO/AO's re-characterization of outstanding receivables as unsecured loans was not permissible under the Act, as it involves computing notional interest on a fictional transaction.
5. Devaluation of Foreign Currency: The devaluation of the AE's home currency (UAH) in 2009 increased the AE's liability towards the assessee, justifying the extended credit period.
6. Business Model Consideration: The business model and geographic region necessitated a longer revenue cycle, and the AE's significant presence justified better credit terms without charging interest.
7. LIBOR Rate for Imputed Interest: If interest is to be imputed, the LIBOR rate should be applied instead of SBI PLR plus 150 basis points.

DR's Arguments:
The DR argued that the TPO had characterized the amount due from the AE beyond 180 days as a loan, based on the agreement between the parties. The DRP's order was justified, and the CUP method was appropriately applied.

Tribunal's Analysis:
The Tribunal noted that an uncontrolled entity expects a market rate of return on its working capital investment. High levels of working capital create costs, necessitating appropriate adjustments to bring parity in working capital investment. The Tribunal relied on several rulings supporting the necessity of working capital adjustments, including Mercer Consulting India Pvt. Ltd., Mentor Graphics (Noida) Private Limited, and others.

The Tribunal found that the assessee had undertaken a working capital adjustment for the comparable companies, reflecting differences in working capital and profitability. The differential impact of working capital had already been factored into the pricing/profitability of the assessee, making further adjustment on the pretext of outstanding receivables unwarranted and unjustified.

The Tribunal also emphasized the principle of aggregation, as supported by the Hon'ble Delhi High Court in Sony Ericsson Mobile Communication India Pvt. Ltd., where it was held that treating AMP expenses as a separate international transaction is illogical if the comparables and transfer price are accepted.

Conclusion:
The Tribunal allowed the appeal of the assessee, concluding that the differential impact of working capital had already been factored into the pricing/profitability, and any further adjustment was unjustified. The approach of aggregating international transactions pertaining to the sale of goods to AE and receivables arising from such transactions was in accordance with established TP principles and judicial precedence.

The decision was pronounced in the open Court on 31st March, 2015.