2013 (10) TMI 550 - AT - Income Tax

Adjustment of arm s length price - Difference in operating cost of comparable companies - Method for benchmarking of transactions - Held that - According to the TPO operating margin on operating cost in the case of comparable companies works out to 13.88% as against 5% in the case of the assessee company whereas, in order to arrive at the cost, the one time extraordinary expenses, which are not standard expenses for earning income, ought not have been taken into consideration - CIT(A) was justified in reducing the extraordinary expenses for the purpose of arriving at the cost and by adopting such cost as the basis, the rate of profit declared by the assessee would be at arm s length and hence there is no need for making any adjustment - Act does not provide that an assessee has to choose a particular method for benchmarking its transactions. Even if a particular method is chosen at the time of furnishing it study report the company can always support its transactions with another method. In the instant case all the details were furnished before the TPO and the AO to highlight that the average hourly rate charged to the third parties were lower compared to the AE and hence the international transactions were at arm s length - No material on record to justify that the assessee is precluded from taking support from any other method for benchmarking its transactions - Income Tax Act does not preclude the assessee from benchmarking its transactions with the help of any other method other than the one which is taken for consideration in its study report. For the purpose of sub-section (1) of section 92C of the Act the most appropriate method has to be selected by the AO. Rule 10C also provides that most appropriate method shall be the method which is best suited to the facts and circumstances of each particular international transaction - AO/TPO has to exercise their judicial discretion in considering as to whether the method/methods adopted by the assessee is suitable to the facts of the case and if, in their opinion, the method followed by the assessee is not suitable, the AO/TPO has to give show cause notice to the assessee before adopting an appropriate method. Ordinarily, in service contracts, CUP method is more suitable, where an assessee enters into agreement with unrelated third parties on similar lines as that of AE. When such facts are available, the AO/TPO has to give their reasons before rejection of the data furnished by the assessee. If the extraordinary expenses are adjusted, by reducing extraordinary expenses from operating expenses, its berry ratio comes to 1.10 and the operating profit on operating cost comes to 10.40% which is higher than the berry ratio and operating profit of the comparables. Thus even from that angle the assessee s transactions are at arm s length - Decided against Revenue.

Summary

Issues Involved:
1. Justification for excluding "Rites Limited" as a comparable.
2. Methodology for determining the arm's length price.
3. Inclusion of extraordinary expenses in the operating expenses.
4. Application of Transactional Net Margin Method (TNMM) and Comparable Uncontrolled Price (CUP) method.
5. Selection of profit level indicator (PLI).

Issue-wise Detailed Analysis:

1. Justification for excluding "Rites Limited" as a comparable:
The primary contention from the Revenue was that the CIT(A) erred in excluding "Rites Limited" as a comparable. The CIT(A) observed that "Rites Limited" is a Government of India enterprise, engaged in multi-disciplinary consultancy in the field of transportation, infrastructure, and related technologies. It was noted that Rites Limited's contracts, often with foreign governments, had implicit guarantees from the Indian government, making its functional and risk profile significantly different from the assessee. Thus, the CIT(A) concluded that Rites Limited's operations were not comparable to the assessee's, which primarily provided engineering consultancy services to its AE. The Tribunal upheld this view, agreeing that the nature of Rites Limited's activities and its government backing made it an unsuitable comparable.

2. Methodology for determining the arm's length price:
The assessee used the Transactional Net Margin Method (TNMM) with the berry ratio as the profit level indicator (PLI) to benchmark its international transactions. The TPO, however, included Rites Limited as a comparable, which led to a higher average operating profit margin of 13.88% compared to the assessee's 5%. The CIT(A) found that the TPO's inclusion of Rites Limited skewed the results and that the correct application of the TNMM, excluding extraordinary expenses, showed that the assessee's transactions were within the arm's length range.

3. Inclusion of extraordinary expenses in the operating expenses:
The CIT(A) noted that extraordinary expenses should not be included in the operating expenses as they are one-time expenditures that distort the profitability rate. The CIT(A) recalculated the operating margin after excluding these expenses, which resulted in a net operating margin of 9.41%, within the safe harbour limit. The Tribunal agreed with this adjustment, emphasizing that the correct determination of operating costs is crucial for accurate benchmarking.

4. Application of TNMM and CUP method:
The assessee initially used the TNMM but also provided internal CUP data to support its pricing. The TPO and AO rejected this additional method, arguing that the assessee could not change its benchmarking method. However, the CIT(A) accepted the internal CUP data, noting that the average hourly rate charged to third parties was lower than that charged to the AE, indicating that the transactions were at arm's length. The Tribunal supported the CIT(A)'s view, stating that the Income Tax Act does not preclude the use of multiple methods for benchmarking.

5. Selection of profit level indicator (PLI):
The assessee used the berry ratio (operating revenue to operating expenses) as the PLI. The TPO argued that this was not in accordance with Rule 10B, which requires the PLI to be with reference to cost or sales of assets. However, the CIT(A) and the Tribunal found that the berry ratio was appropriate in this case, especially after adjusting for extraordinary expenses, which brought the operating profit margin to 10.40%, higher than the comparables' average.

Conclusion:
The Tribunal upheld the CIT(A)'s decision, concluding that the exclusion of Rites Limited as a comparable was justified, the correct methodology and PLI were applied, and the international transactions of the assessee were at arm's length. Consequently, the appeal filed by the Revenue was dismissed.