2020 (7) TMI 601 - AT - Income Tax

Disallowance of royalty expenses - Disallowance u/s 40A(2)(b) - disallow the excessive or reasonable expenditure - AO has only questioned the fair market value of the expenses - HELD THAT - In the instant case the AO has only compared royalty expenses of the preceding assessment year and no efforts have been made for identifying the fair market value of such expenses during relevant period, which is one of the requirement for invoking the provisions of section 40A(2)(b). Under transfer pricing provisions the arm s-length price is compared with similar transactions. Though the provisions of section 40A(2)(b) are general provision as compared to the specific provisions of the transfer pricing, the AO was required to compare the royalty expenses paid in case of the similar product by other companies during the relevant period. AO has not done any such exercise and only made basis of expenses paid in earlier years. As assessee contended that in assessment year 2013-14 the transaction of the royalty expenses were subjected to transfer pricing provisions. As submitted that in assessment year 2013-14 average royalty payment was 2.99% of the sales, which stands accepted by the Department and therefore, no disallowance should be made in the year under consideration, where the royalty expenses are only 2.77% of the sales. This contention is rejected as the fair market value of the expenses have to be identified for the relevant year and percentile of the earlier year cannot be made basis for comparison. Disallowance made out of royalty expenses is deleted. The ground of the appeal is accordingly allowed. Transaction of the royalty expenses between the assessee and its Associated Enterprises (AEs), is international transaction and therefore its arm s-length price can be determined only under the transfer pricing provisions and not under the provision of the section 40A(2)(b) - when there is specific provisions for dealing with the issue of expenses paid to related party under transfer pricing provisions, the general provisions under section 40A(2)(b) of the Act should not be invoked. We have noticed that this issue was not raised before the lower authorities and it has been raised before us for the first time that too as oral argument and not either as regular ground or additional ground.

Summary

Issues Involved:
1. Validity of notice issued under section 143(2).
2. Disallowance under section 40A(2)(b) for excessive royalty payments to a related party.

Detailed Analysis:

1. Validity of Notice Issued Under Section 143(2):
The appellant contended that the notice issued under section 143(2) was mechanical and not in accordance with jurisdictional conditions stipulated under the Act, rendering subsequent proceedings void ab initio. However, the learned Counsel did not raise any arguments in support of this ground during the appeal. Consequently, the Tribunal dismissed this ground as not pressed.

2. Disallowance Under Section 40A(2)(b) for Excessive Royalty Payments:
The main contention revolved around the disallowance of ?3,66,82,337 under section 40A(2)(b) for excessive royalty payments to a related party. The assessee argued that similar royalty expenses were allowed in previous assessment years (2013-14 and 2014-15) and that the royalty payment percentage was consistent with those years. The assessee further argued that the transaction was an international one with associated enterprises, and thus, transfer pricing provisions should have been invoked instead of section 40A(2)(b).

Tribunal's Findings:
- The Tribunal noted that the Assessing Officer (AO) questioned the fair market value of the expenses but did not address the legitimate needs of the business or the benefits derived from the expenses.
- The AO compared the royalty expenses of the preceding year and noted an abnormal increase in royalty rates for certain products, ranging from 39% to 67.5%, without sufficient justification from the assessee.
- The Tribunal emphasized that for invoking section 40A(2)(b), the AO must form an opinion on whether the expenses exceed the fair market value or are not in accordance with the legitimate needs of the business. The AO failed to identify the fair market value of the expenses during the relevant period and only compared them with previous years' expenses.
- The Tribunal rejected the assessee's argument that the royalty payment percentage from earlier years should be used as a basis for comparison, stating that the fair market value must be identified for the relevant year.
- The Tribunal found that the AO's reliance on an unregistered agreement to invoke section 40A(2)(b) was misplaced, as the law does not require an agreement to be registered for the provision to apply.

Conclusion:
- The Tribunal deleted the disallowance of ?3,66,82,337, stating that the AO did not adequately justify the excessive royalty payments by comparing them with similar transactions during the relevant period.
- The Tribunal did not adjudicate on the argument regarding the applicability of transfer pricing provisions versus section 40A(2)(b) as it was raised for the first time during the appeal and was rendered academic due to the decision on merits.

Final Judgment:
The appeal of the assessee was allowed, and the disallowance of ?3,66,82,337 under section 40A(2)(b) was deleted. The order was pronounced in the open court on 23rd July, 2020.