2021 (5) TMI 748 - AT - Income Tax

TP Adjustment - upward adjustment under the provisions of section 92 - ALP determination - profit level indicators for working out the ALP - PBIT or PBDIT - - whether PBIT or PBDIT should be taken as profit level indicators for working out the ALP with respect to the transactions carried out by the assessee with its associated enterprise? - HELD THAT - The purpose of transfer pricing provisions is to ensure that the companies which are connected with each other and operating internationally, such companies should not divert their income to another country. In other words, the price charged by one company from its associated enterprises should not be influenced by their connections between them. Such price should have been at the arm length price, meaning thereby the price/service or the cost should be at a value which is agreeable to the independent/unrelated parties under uncontrolled situations/circumstances. How to determine the ALP with respect to the transactions carried out between two associated enterprises ? - adjustments in the depreciation - The price or the margin of one company (tested party), depending upon facts and circumstances, should be compared with the companies which are comparable in terms of functions, capital employed, debt equity ratio, turnover, risk, contractual terms, assets employed etc. If any of the item such as capital employed, turnover is not comparable to the tested party for any reason, then the necessary adjustments are required to be made. The amount of depreciation claimed by the assessee in the ratio of turnover stands at 9.366% whereas average ratio of depreciation of the comparable companies claimed to their turnover stands at 2.086%. Thus it is inferred that the adjustments in the depreciation is required to be made. Now, the issue arises how to make the adjustments. In this regard we find that there is no guidelines or the provisions of law providing the mechanism for making the adjustments with respect to the depreciation. Furthermore, it also appears that there cannot be any guidelines or formula for making such adjustments, rather it depends upon various factors and circumstances. However, we find that none of the authorities below has made such adjustments while determining the PLI for working out the ALP despite such contention was raised by the assessee before the learned CIT (A). See ERHARDT LEIMER (INDIA) PRIVATE LIMITED VERSUS ASST. COMMISSIONER OF INCOME TAX 2016 (12) TMI 1792 - ITAT AHMEDABAD CIT (A) has equated the amount of depreciation with the repair and maintenance expenses. As per the learned CIT (A) if the assessee is claiming higher depreciation than the comparable companies, it implies that the assessee must be claiming less repair and maintenance expenses than the comparable companies. Accordingly, the learned CIT (A) rejected the contention of the assessee for making the adjustments with respect to the depreciation. In this connection, we find that the repairs and maintenance expenses cannot be equated/compared with the depreciation. These are two independent items of expenses. There is no guarantee that if the depreciation is higher then, the repair and maintenance expenses will be lower or vice versa. Accordingly we are not convinced with the reasoning of the learned CIT (A). In view of the above and in the interest of justice we hold that the AO should have taken the PBDIT as the profit level indicator while working out the arm length price with respect to the international transactions carried out by the assessee with its AE. - Decided in favour of assessee.

Summary

Issues Involved:
1. Determination of the most appropriate method (MAM) for calculating the arm's length price (ALP).
2. Treatment of rental income in computing operating profit.
3. Selection of profit level indicator (PBIT vs. PBDIT) for determining ALP.
4. Comparability of selected companies for transfer pricing purposes.

Detailed Analysis:

1. Determination of the Most Appropriate Method (MAM) for Calculating ALP:
The assessee used the Cost Plus Method (CPM) and Comparable Uncontrolled Price (CUP) method to determine the ALP for its international transactions. The Assessing Officer (AO) rejected these methods and adopted the Transactional Net Margin Method (TNMM) as the MAM. The AO selected three comparables and calculated the arithmetic mean of their operating margins at 9.80%, whereas the assessee's margin was 1.40%. The CIT (A) upheld the AO's selection of TNMM, noting that the assessee did not provide comparables to support its methods (CPM and CUP) and only conducted a search using the TNMM method after the AO’s show cause notice.

2. Treatment of Rental Income in Computing Operating Profit:
The CIT (A) addressed the issue of rental income, which the AO had excluded from operating income. The CIT (A) agreed with the assessee's contention that if rental income is excluded, related expenses should also be excluded. However, the CIT (A) ultimately decided that rental income should be treated as part of the operating income to automatically account for related expenses, directing the AO to adjust the operating profit accordingly.

3. Selection of Profit Level Indicator (PBIT vs. PBDIT) for Determining ALP:
The assessee argued that due to higher depreciation costs compared to comparables, the Profit Before Depreciation, Interest, and Taxes (PBDIT) should be used as the profit level indicator instead of Profit Before Interest and Taxes (PBIT). The CIT (A) rejected this, reasoning that higher depreciation in new entities is offset by higher repair and maintenance costs in older entities. The Tribunal, however, found that depreciation and repair/maintenance are independent expenses and cannot be equated. The Tribunal ruled in favor of the assessee, directing the AO to use PBDIT as the profit level indicator.

4. Comparability of Selected Companies for Transfer Pricing Purposes:
The assessee contended that the turnover of selected comparables was significantly higher than its own, suggesting that companies with similar turnover should be used. The Tribunal did not find it necessary to adjudicate this issue separately, as it had already ruled in favor of using PBDIT, rendering this contention moot.

Conclusion:
The Tribunal allowed the appeal filed by the assessee, directing the AO to use PBDIT as the profit level indicator for determining the ALP of the international transactions. The Tribunal emphasized the need for adjustments in depreciation and rejected the CIT (A)'s reasoning equating depreciation with repair and maintenance expenses. The appeal was allowed, and the order was pronounced on 24/03/2021 at Ahmedabad.