2020 (1) TMI 606 - AT - Income Tax

Shortfall in royalty charged by the assessee from its AE - A.O/TPO working out the royalty @3% on the entire sales of the AE - HELD THAT - As claimed, the royalty was consistently being received by the assessee on the manufacturing sales-exports of its AE, viz. M/s Zodiac Clothing Company, UAE LLC. On the basis of our aforesaid deliberations, we are of the considered view that on a conjoint reading of the agreement dated 04.04.2008 (which is a renewal of the earlier agreement dated 09.11.2002) and the letter of understanding dated 02.01.2003, the royalty /fees for technical know-how was to be received by the assessee only on the manufacturing sales (export) of ₹ 46,71,99,283/- i.e AED 3,79,66,396/- . Accordingly, we direct the A.O/TPO to delete the TP adjustment of ₹ 68,63,889/- that was made in the hands of the assessee on account of royalty shortfall in respect of its international transaction of provision of technical assistance and advisory services to its AE, viz. M/s Zodiac Clothing Company, UAE LLC. Adopting the gross margin rate of 26.98% (trading segment-AE) - adjustment towards shortfall of the amount recoverable by the assessee on account of supply of samples to its AE - HELD THAT - No feasible comparison could have been made between the mark-up of 7.5% on cost of samples (after recovering salvage value) and the segmental profitability of trading segment of 26.98% i.e gross profit on cost, for determining the ALP of the aforesaid transaction. Apart from that, we find that the TPO had erroneously compared the margins of the controlled transaction i.e mark-up of 7.5% on cost of samples (fabrics) charged to A.E with the segmental profitability of the trading segment of 26.98% (average) of the AE segment. Aforesaid comparability analysis carried out by the TPO, wherein he has compared the margins of controlled transactions is fundamentally incorrect and defeats the very purpose of determining the arm s length price. In fact, the TPO was obligated to have made a comparison between controlled transactions and uncontrolled transactions i.e margins from transactions with AE and margins from transactions with third parties i.e non-AE s, which we find he had failed to do. Adjustment made by the A.O/TPO towards shortfall of the amount recoverable by the assessee on account of supply of samples to its AE cannot be sustained and is liable to be vacated. We thus in terms of our aforesaid observations direct the A.O/TPO to delete the addition of ₹ 10,16,356/-. The Ground of appeal No. 3 is allowed. Disallowance u/s 14A - claim of the ld. A.R that as the assessee had sufficient own funds which would justify the investments made in the exempt income yielding assets, therefore, no disallowance of any part of the correlating interest expenditure was called for - HELD THAT - claim of the ld. A.R is principally fortified by the order of the Hon ble High Court of Bombay in the case of CIT Vs HDFC Bank Ltd. . 2014 (8) TMI 119 - BOMBAY HIGH COURT as observed that where the assesse's capital, profit reserves, surplus and current account deposits were higher than the investment in tax-free securities, it would have to be presumed that investment made by the assessee would be out of the interest-free funds available with assessee and no disallowance would be warranted u/s 14A. Although we are principally in agreement with the aforesaid claim of the ld. A.R, however, in the absence of the facts and figures in support of the said claim, we refrain from adjudicating the same. Accordingly, we restore the issue to the file of the A.O, who shall after verifying the veracity of the aforesaid claim of the assessee, therein readjudicate the same. Ground allowed for statistical purpose.

Summary

Issues Involved:
1. Adjustment/Addition to Total Income
2. Transfer Pricing Adjustment on Account of Royalty Shortfall
3. Transfer Pricing Adjustment on Account of Shortfall in Recovery of Supplying Samples
4. Initiation of Penalty Proceedings under Section 271(1)(c) of the Income Tax Act
5. Corporate Tax Adjustment under Section 14A

Detailed Analysis:

1. Adjustment/Addition to Total Income:
The assessee company filed appeals against the orders passed by the Assessing Officer (AO) under Section 143(3) read with Section 144C(13) of the Income Tax Act for the assessment years 2011-12 and 2012-13. The appeals were consolidated and disposed of by a common order. The primary contention was the proposed addition of INR 7,880,245 to the assessee's total income of INR 198,044,775 for A.Y 2011-12.

2. Transfer Pricing Adjustment on Account of Royalty Shortfall:
The assessee contested the addition of INR 68,63,889 for A.Y 2011-12 and INR 9,297,422 for A.Y 2012-13, which was proposed by the Transfer Pricing Officer (TPO) and confirmed by the Dispute Resolution Panel (DRP). The TPO had worked out the royalty at 3% on the entire sales of INR 700,362,813 of the Associated Enterprise (AE), resulting in the said adjustments. The TPO rejected the assessee's methodology, which was based on an agreement and a letter of understanding that excluded certain sales from royalty computation. The Tribunal found merit in the assessee's claim that the agreement dated 04.04.2008 was an extension of an earlier agreement with the same terms and conditions and directed the AO/TPO to delete the TP adjustment of INR 68,63,889 for A.Y 2011-12. The same reasoning applied to A.Y 2012-13, leading to the deletion of the TP adjustment of INR 9,297,422.

3. Transfer Pricing Adjustment on Account of Shortfall in Recovery of Supplying Samples:
The assessee challenged the addition of INR 10,16,356 for A.Y 2011-12. The TPO had applied a gross margin rate of 26.98% (trading segment-AE) to determine the arm's length price (ALP) for the recovery of supplying samples, which the assessee had marked up by 7.5% on cost. The Tribunal held that no feasible comparison could be made between the 7.5% mark-up and the segmental profitability of trading segment of 26.98%. The TPO's approach of comparing margins of controlled transactions was fundamentally incorrect. Therefore, the Tribunal directed the AO/TPO to delete the addition of INR 10,16,356.

4. Initiation of Penalty Proceedings under Section 271(1)(c) of the Income Tax Act:
The assessee objected to the initiation of penalty proceedings under Section 271(1)(c). The Tribunal found this ground of appeal to be premature and dismissed it for both assessment years.

5. Corporate Tax Adjustment under Section 14A:
For A.Y 2012-13, the assessee contested the disallowance of INR 8,54,221 under Section 14A read with Rule 8D, which was against the INR 3,56,230 offered by the assessee. The Tribunal noted that if the assessee's capital, profit reserves, surplus, and current account deposits were higher than its investment in tax-free securities, no disallowance of interest expenditure was warranted under Section 14A. The issue was restored to the AO for verification, and the disallowance would be vacated if the assessee's claim was found correct.

Conclusion:
The appeal for A.Y 2011-12 was allowed, and the appeal for A.Y 2012-13 was allowed for statistical purposes. The Tribunal directed the deletion of the TP adjustments related to royalty shortfall and supply of samples for both years and restored the issue of disallowance under Section 14A for verification. The initiation of penalty proceedings under Section 271(1)(c) was dismissed as premature.