A manufacturer of tractor cannot be considered as comparable with manufacturer of harvester combine, simply because both machines fall in overall category of ‘Agricultural equipments’
IN THE ITAT DELHI BENCH ‘I’
Deputy Commissioner of Income-tax, Circle- 3 (1), New Delhi
Claas India (P.) Ltd.
AND A.T. VARKEY, JUDICIAL MEMBER
IT APPEAL NO. 1783 (DELHI) OF 2011
CO NO. 179 (DELHI) OF 2011
[ASSESSMENT YEAR 2005-06]
AUGUST 12, 2015
Amrendra Kumar, CIT DR and Ms. Y. Kakkar, Sr. DR for the Appellant.S.P. Singh, CA, Manomeet Dalal and Vishnu Goel, Advs. for the Respondent.
R.S. Syal, Accountant Member – This appeal by the Revenue and the Cross Objection by the assessee emanate from the order passed by the CIT(A) on 31.01.2011 in relation to the assessment year 2005-06.
2. First ground of the Revenue’s appeal has two parts. The first segment challenges the inclusion of two companies by the ld. CIT(A) in the list of comparables. The only issue raised by the assessee in its cross objection is against the affirmation of inclusion of one company in the list of final set of comparables. The ld. AR did not press the cross objection. As such, we are confined to deciding only as to whether the ld. CIT(A) was justified in directing the inclusion of two companies in the final set of comparables, namely, M/s Eicher Motors and M/s Force Motors.
3. Briefly stated, the facts of the case are that the assessee was established as an Indian company in 1990 as a wholly owned subsidiary of a Claas KGaA mbH, Germany. Until 31.8.2002, the assessee was known as Escorts Claas Ltd., with 60:40 joint venture between Escorts India Ltd., and Claas, Germany. Thereafter, the entire shareholding was acquired by Claas, Germany. The assessee’s main activity is manufacture and sale of harvester combines in India and export of harvester combines and engine harvester combines and engine related products, licensed by Claas Group. The assessee manufactures two types of harvester combines, namely, wheel based and track based. Certain international transactions were reported by the assessee including purchase of raw materials; sale of harvesters and spares; purchase of computer; payment for administrative and software support services; and receipt of market support services. To demonstrate that its international transactions were at arm’s length price (ALP), the assessee applied the Transactional Net Margin Method (TNMM) as the most appropriate method with the Profit Level Indicator (PLI) of Operating Profit/Total Cost (OP/TC). All the international transactions were aggregated and a combined OP/TC was computed. The assessee chose three companies as comparable, namely, Eicher Motors, Force Motors and VST Tractors & Tillers. The assessee claimed that its adjusted OP/TC was at arm’s length. The TPO included M/s Punjab Tractors Ltd. (Segment), as one of the comparables, and excluded Eicher Motors and Force Motors from the list of comparables drawn by the assessee. In a nutshell, the TPO considered two companies as comparables, viz., VST Tractors & Tillers and Punjab Tractors Ltd. (Seg.) with their average OP/TC at 11.92%. The assessee challenged the exclusion of Eicher Motors and Force Motors before the ld. CIT(A) along with the inclusion by the TPO of Punjab Tractors Ltd. (Seg.). The ld. CIT(A) upheld the inclusion of Punjab Tractors Ltd.(Seg.) and also directed to include Eicher Motors and Force Motors in the final set of comparables. The Revenue is aggrieved against the inclusion of Eicher Motors and Force Motors. Since the assessee has not pressed its cross objection, through which the inclusion of Punjab Tractors Ltd. (Seg.) was assailed, it becomes manifest that VST Tractors and Tillers along with Punjab Tractors Ltd., (Seg.) have been accepted by the assessee as proper comparables. Now, we will deal with the Revenue’s challenge to the inclusion of M/s Eicher Motors and M/s Force Motors.
M/s Eicher Motors
4.1 The assessee included this company in the list of comparables. The TPO observed that the most of the sales of this company were of tractors. Since the assessee was engaged in the business of manufacturing and selling harvester combines, the TPO held this company to be incomparable. The ld. CIT(A) noticed that the assessee was following TNMM as the most appropriate method. Since the harvester combines fall within the overall category of agricultural equipments, the ld. CIT(A) held this company as comparable. The Revenue is aggrieved against the inclusion of this company in the final list of comparables drawn by the ld. first appellate authority.
4.2 We have heard the rival submissions and perused the relevant material on record. There is no dispute on the fact that the assessee is following the TNMM as the most appropriate method. It is also admitted that the assessee deals in harvester combines and not tractors. It is equally unopposed that Eicher Motors is engaged in the business of manufacture and sale of tractors and not harvester combines. The question arises as to whether Eicher Motors, manufacturing tractors can be considered as a good comparable of the assessee, manufacturing harvester combines. The first and the foremost parameter for testing the comparability of a company is its functional similarity. Other factors follow later on. Functional similarity issine qua non for any comparability analysis. The degree of functional similarity may vary depending upon the method of determining arm’s length price (ALP). Whereas the Comparable Uncontrolled Method (CUP) demands the scale of similarity of a highest order, the same can be compromised to some extent under the TNMM. Compromising similarity to some extent under the TNMM does not mean switching over to an altogether different product. A comparison even under the TNMM is contemplated with ‘a comparable uncontrolled transaction.‘ Unless a company is functionally similar, there can be no question of treating it as a probable comparable in the first instance for further evaluation.
4.3 Adverting to the facts of the instant case, we find that the ld. CIT(A) has held a tractor manufacturer as comparable with a harvester combine manufacturer. Whereas a harvester combine is a machine that harvests green crops by combining three separate operations, namely, reaping, threshing and winnowing, a tractor is a vehicle used for drawing or pulling. Further, a combine is several times dearer than a tractor. It can be observed that the functions of both, along with their respective price tags, are entirely different from each other. It is beyond our comprehension as to how a manufacturer of a tractor can be considered as comparable with the manufacturer of harvester combine. Simply because both the machines fall in the overall category of `Agricultural equipments’, it does not mean that they become comparable to each other. If one accepts such a logic as applied by the ld. CIT(A), then the manufacturer of other agricultural equipments, such as tillers, would also become comparable with a manufacturer of tractor or harvester combine and vice versa, which proposition is absolutely absurd. In view of the inherent differences in the characteristics, usage and price of harvester combine and tractors, we are unable to countenance the view taken by the ld. CIT(A) in treating M/s Eicher Motors as a good comparable. The impugned order on this score is overturned and the view of the TPO is restored.
M/s Force Motors
5. The facts and circumstances of M/s Force Motors are mutatis mutandis similar to those of M/s Eicher Motors. This company, initially considered as comparable by the assessee, was also excluded by the TPO on the same reasoning as given for M/s Eicher Motors and the ld. CIT(A) also upheld the inclusion of this company in the list of comparables by following the same reasoning as given by him for M/s Eicher Motors. In view of our above discussion made in the context of M/s Eicher Motors, we hold that M/s Force Motors cannot be considered as a good comparable. The impugned order on this score is reversed.
Capacity utilization adjustment
6. The second segment of Ground no. 1 of the Revenue’s appeal is against the allowing of capacity adjustment in respect of certain items of expenses, which was denied by the TPO.
7. The facts apropos this issue are that the assessee claimed to have worked at a capacity of 29% during the year in question. It was further claimed that the three comparables chosen by it worked at the average capacity utilization of 44%. That is how, the assessee claimed capacity utilization adjustment by reducing its operating costs accordingly. In support of deduction, the assessee filed a report of Mr. Chandra Wadhva, a Cost Accountant. As per this report, the capacity utilization of the assessee as well as the comparables was initially raised to 100%. The TPO partly accepted the claim of the assessee. He considered VST Tractors and Tillers and Punjab Tractors Ltd. (Seg.) for the purposes of allowing capacity adjustment with an average capacity utilization taken at 54%. Thereafter, he restricted the reduction in operating costs of the assessee due to capacity utilization, to some Administrative costs and other expenses. As against the assessee’s actual deduction of Rs. 6,65,79,916 for such selective items of administrative and other expenses, the TPO adjusted such costs to Rs. 6,30,30,739 by applying the factor of 29/54 (29%, being, the assessee’s capacity utilization and 54%, being, the average capacity utilization of comparables chosen by him). Similarly, he reduced the amount of Depreciation claimed by the assessee at Rs. 1,19,60,921 to Rs. 64,23,458 by applying the same factor of 29/54. After allowing this capacity utilization adjustment, he determined OP/TC of the assessee at a loss of (-) 7.78%. Total cost of the assessee was taken at Rs. 36.88 crore. By applying the arithmetic mean of the profit rate of comparable companies chosen by him at 11.92%, he proposed a transfer pricing adjustment of Rs. 7,26,60,103/-, for which addition was made by the AO. The ld. CIT(A) accepted the assessee’s contention about not making any TP adjustment in relation to non-AE transactions. The Revenue is not aggrieved to that extent. As regards adjustment for capacity utilization, the ld. CIT(A), by considering the companies finally held by him as comparable, applied the factor of 29/46 for reducing the operating costs actually incurred by the assessee. Apart from the adjustments allowed by the TPO on Administration expenses and Depreciation, the ld. CIT(A) also reduced Advertisement & Marketing expenses, Employee cost (by taking entire employee cost, other than bonus, at Rs. 35515709 as fixed). The Revenue is aggrieved against the allowing of capacity utilization adjustment to this extent by the ld. CIT(A).
8. We have heard the rival submissions and perused the relevant material on record. Before embarking upon the question of allowability and extent of capacity adjustment under the TNMM, we want to make it clear that the assessee reduced its operating costs by considering its capacity utilization vis-à-vis that of comparables and resultantly claimed that its increased profit as a result of such reduced operating costs be compared with that of the comparables. The TPO has also agreed in principle with the otherwise availability of the capacity adjustment. The issue of allowing capacity adjustment before us can be divided into two sub-issues for consideration, viz., first, whether the adjustment should be allowed in the hands of the assessee as has been done by the authorities below or comparables and second, how to compute capacity utilization adjustment under the TNMM. We will deal with these aspects one by one.
i. Capacity adjustment should be allowed in whose hands ?
9.1 It has been noticed above that the assessee claimed idle capacity adjustment by reducing its own operating costs. It is further observed that the authorities below have reduced the amount of adjustment by excluding certain costs from the ambit of the costs qualifying for adjustment. However, the adjustment has been ultimately allowed from the operating costs incurred by the assessee. In such circumstances, the question arises as to whether the action of the authorities in allowing the reduction of the operating costs incurred by the assessee, is in accordance with law? In order to find answer to this question, we need to refer to the manner of computation of the arm’s length price under TNMM, which has been set out in Rule 10B(1)(e) as under:—
“(e) transactional net margin method, by which,—
|(i)||the net profit margin realised by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base ;|
|(ii)||the net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base ;|
|(iii)||the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market ;|
|(iv)||the net profit margin realised by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii) ;|
|(v)||the net profit margin thus established is then taken into account to arrive at an arm’s length price in relation to the international transaction.”|
9.2 Sub-clause (i) in the process of determination of the ALP under the TNMM talks of the computation of net operating profit margin realized by the assessee from an international transaction. Sub-clause (ii) is the computation of net operating profit margin realized by an unrelated enterprise from a comparable uncontrolled transaction. This refers to determining the operating profit margin of comparables with the same base as that of the assessee. Sub-clause (iii) provides that the net profit margin realized by a comparable company, determined as per sub-clause (ii) above, ‘is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions,. . . . . . which could materially affect the amount of net profit margin in the open market.’ It is this adjusted net profit margin of the unrelated transactions or of the comparable companies, as determined under sub-clause (iii), which is used for the purposes of making comparison with the net profit margin realized by the assessee from its international transaction as per sub-clause (i).
9.3 Sub-rule (2) of Rule 10B provides that the comparability of an international transaction with an uncontrolled transaction shall be judged with reference to certain factors which have been enumerated therein. Rule 10B(3) states that an uncontrolled transaction shall be comparable to an international transaction, if either there are no differences between the two or a ‘reasonably accurate adjustment can be made to eliminate the material effects of such differences.‘ When we read sub-clauses (ii) & (iii) of Rule 10B(1)(e) in juxtaposition to sub-rules (2) & (3) of rule 10B, the position which emerges is that the net operating profit margin of comparable companies calls for adjustment in such a manner so as to bring both the international transaction and comparable cases at the same pedestal. In other words, if there are no differences in these two, then the average of the net operating profit margin of the comparable companies becomes a benchmark. However, in case there are some differences between the comparables and the assessee, then the effect of such differences should be ironed out by making suitable adjustment to the operating profit margin of comparables. That is the way for bringing both the transactions, namely, the international transaction and the comparable uncontrolled transactions, on the same platform for making a meaningful and effective comparison. The above analysis overtly transpires that the law provides for adjusting the profit margin of comparables on account of the material differences between the international transaction of the assessee and comparable uncontrolled transactions. It is not the other way around to adjust the profit margin of the assessee. In other words, the net operating profit margin realized by the assessee from its international transaction is to be computed as such, without adjusting it on account of differences with the comparable uncontrolled transactions. The adjustment, if any, is required to be made only in the profit margins of the comparables.
9.4 Reverting to the facts of the instant case, we find that the authorities below have adjusted the operating costs of the assessee in allowing the capacity adjustment. As against that, the correct course of action provided under the law is to adjust the operating costs of the comparable and their resultant operating profit. There is hardly need to accentuate that there can be no estoppel against the law. Once the law enjoins for doing a particular thing in a particular manner alone, it is not open to anyone to adopt a contrary or different approach. As the authorities below have adopted a course of action in allowing adjustment, which is not in consonance with law, we cannot approve the same. The impugned order is set aside and the matter is restored to the file of the TPO/AO for giving effect to the amount of idle capacity adjustment in the operating profit of the comparables and not the assessee.
ii. How to compute capacity utilization adjustment under TNMM : —
10.1 Under the TNMM, the ALP of an international transaction is determined by computing and comparing the percentage of operating profit margin realized by the assessee with that of the comparables. We have noticed above that the difference in the capacity utilizations is an important factor, which needs to be adjusted. No mechanism has been given under the Act or the rules for computing the amount of capacity utilization adjustment.
10.2 On an overall understanding, we feel that under the TNMM, the first step in granting capacity utilization adjustment is to ascertain the percentage of capacity utilization by the assessee and comparables. There can be no difficulty in working out these percentages. The second step is to give effect (positive or negative) to the difference in the percentage of capacity utilizations of the assessee vis-à-vis comparables, one by one, in the operating profit of comparables by adjusting their respective operating costs. Operating costs can be either fixed or variable or semi-variable. One needs to split semi-variable costs into the fixed part and variable part. In so far as the variable costs and the variable part of the semi-variable costs are concerned, these remain unaffected due to any under or over utilization of capacity. Accordingly, such variable operating costs remain unchanged. The adjustment is called for only in respect of the fixed operating costs and fixed part of semi-variable costs. Such costs are scaled up or down by considering the percentage of capacity utilization by the assessee and such comparable. It can be illustrated with the help of a simple example. Suppose the fixed costs incurred by a comparable (say, A) are Rs. 100 and it has capacity utilization of 50% as against the capacity utilization of 25% by the assessee. The above percentages show that the assessee has incurred full fixed costs with 25% of the utilization of its capacity, as against A incurring full fixed costs with 50% of its capacity utilization. This divulges that the assessee has incurred relatively more fixed costs and A has incurred lower costs. In order to make an effective comparison, there arises a need to obliterate the effect of this difference in capacity utilizations. It can be done by proportionately scaling up the fixed costs incurred by A so as to make it fully comparable with the assessee. This we can do by increasing the fixed costs of A to Rs. 200 (Rs. 100 into 50/25) as against the actually incurred fixed costs by it at Rs. 100. When we compute operating profit of A by substituting the fixed costs at Rs. 200 with the actually incurred at Rs. 100, it would mean that the fixed costs incurred by the assessee and A are at the same capacity utilization. There can be converse situation as well. Suppose the fixed costs incurred by a comparable (say, B) are Rs. 100 and it has capacity utilization of 25% as against the capacity utilization of 50% by the assessee. The above percentages show that the assessee has incurred full fixed costs at 50% of the utilization of its capacity, as against B incurring full fixed costs at 25% of the capacity utilization. This deciphers that the assessee has incurred relatively lower fixed costs and B has incurred higher costs. This difference in capacity utilizations can be eliminated by proportionately scaling down the fixed costs incurred by B so as to make it fully comparable. This we can do by reducing the fixed costs of B to Rs. 50 (Rs.100 into 25/50) as against the actually incurred fixed cost by it at Rs.100. When we compute operating profit of B by substituting the fixed costs at Rs. 50 with the actually incurred at Rs. 100, it would mean that the fixed costs incurred by the assessee and B are at the same capacity utilization level.
10.3 Turning to the facts of the instant case, we find that both the TPO as well as the ld. CIT(A) have proceeded on a wrong premise not only by allowing capacity utilization adjustment in the assessee’s profit, which is contrary to the legal position as discussed above, but also by considering all the comparables as one unit with the average percentage of their respective capacity utilizations. It is further observed that in the calculation of such capacity utilization adjustment, the ld. CIT(A) has considered four companies as comparable, which view has been modified by us supra inasmuch as we have held that M/s Eicher Motors and M/s. Force Motors are incomparable. Naturally, they would also go out of reckoning in the computation of idle capacity utilization adjustment. In the absence of the availability of financials of all the comparable companies, it is not possible at our end to work out the amount of capacity adjustment in the manner discussed above. Ergo, we set aside the impugned order and direct the TPO/AO to work out the amount of capacity utilization adjustment afresh in terms of our above observations. Needless to say, the assessee will be allowed a reasonable opportunity of hearing in such fresh proceedings.
11.1 Ground no. 2 is against the deletion of addition of Rs. 61,762/- on account of capitalization of Software expenses. Succinctly, the facts of this ground are that the assessee claimed deduction amounting to Rs. 27,97,008/- towards software expenses. On perusal of details of such expenses, it was observed by the AO that a sum of Rs. 1,49,611/- was spent as subscription for anti-virus software, Rs. 2,895/- for website charges and Rs. 1,900/- towards purchase of modem. The AO capitalized these three items with a total of Rs. 1,54,406/- and allowed depreciation as applicable to computers on such amount @ 60%. This led to the making of addition of Rs. 61,762/-. The ld. CIT(A) deleted the addition.
11.2 After considering the rival submissions and perusing the relevant material on record, we find that the first item is anti-virus software subscription for which a sum of Rs. 1,49,611/- was paid by the assessee. On being called upon to produce the bill for this software subscription, the ld. AR expressed his inability as the same was not readily available. The extent of deductibility of this amount depends upon the period for which this subscription and from the date on which it was paid. If it is given for a period of more than one year, then naturally, the amount relatable to the period beyond the first year, would not be admissible for deduction during the year in question. If the amount is paid for one year, then the subscription period covered during the year will be deductible and the remaining amount will qualify for deduction in the succeeding year. In the absence of the availability of the date and the period of subscription period, we set aside the impugned order on this issue and send the matter to the AO for deciding it in conformity with our above observations.
11.3 Coming to the Website charges of Rs. 2,895/-, we find that the creation of website is an advantage which facilities carrying on business more efficiently and profitably leaving fixed capital untouched. The Hon’ble Supreme Court in Empire Jute Co. Ltd. v. CIT  124 ITR 1 has held that such expenses should be considered as revenue in nature. The Mumbai bench of the tribunal vide its order dated 9.2.2011 in Addl. CIT v. Avendus Advisors (P.) Ltd. [IT Appeal Nos. 5860 (Mum.) of 2008 & 2712 (Mum.) of 2009] has held that website development charges are revenue in nature. Respectfully following the precedent, we uphold the impugned order to this extent.
11.4 The third amount is price of modem. In our considered opinion, the same is a capital expenditure eligible for depreciation @ 60% as applicable to computer. Our view is fortified by the judgment of the Hon’ble Delhi High Court inCIT v. BSES Yamuna Powers Ltd.  40 taxmann.com 108/ 220 Taxman 51 (Mag.) and that of the Special bench of the tribunal in Dy.CIT v. Datacraft India Ltd.  40 SOT 295 (Mum.) (SB). The impugned order is reversed and the action of the AO is restored to this extent. This ground is disposed of accordingly.
12.1 Ground no. 3 is against the deletion of addition of Rs. 37,03,000/- on account of deferred revenue expenditure. The factual matrix of this ground is that the assessee capitalized certain sum for development of a new product called TAF60. Till 30.9.2003, a sum of Rs. 156 lac was capitalized and treated as capital work-in-progress. A further sum of Rs. 28.32 lac was incurred on its development between 1.10.2003 to 31.3.2004. The assessee capitalized the entire sum and claimed deduction @ 25% of the same in the earlier years and in the year in question. The AO treated this amount as capital expenditure and did not allow any deduction. The ld. CIT(A) accepted the assessee’s claim.
12.2 After considering the rival submissions and perusing the relevant material on record, we find that similar issue came up for consideration before the Tribunal in the assessee’s own case for the AY 2007-08. A copy of such order has been placed on record in which this issue has been decided in the assessee’s favour. In the absence of the ld. DR bringing to our notice any distinguishing feature in the facts of the current year vis-à-vis the referred year, respectfully following the precedent, we uphold the impugned order in allowing deduction for a sum of Rs. 37.03 lac, which has been admittedly claimed on the same percentage of 25% as for the year dealt with by the tribunal. This ground fails.
13.1 The last ground is against the deletion of addition of Rs. 2 lac on account of disallowance of Miscellaneous expenses. The assessee debited a sum of Rs. 20.14 lac under this head. For non-availability of certain details, the AO made an ad hoc disallowance of Rs. 2 lac, which was deleted in the first appeal.
13.2 Having heard the rival submissions and perused the relevant material on record, we are satisfied with the decision of the ld. CIT(A) in deleting this ad hoc addition made by the AO. If the AO was not satisfied with the justification of some expenses, he ought to have specifically pointed out such expenses rather than making an ad hoc disallowance of Rs.2 lac. We, therefore, approve the view taken by the ld. CIT(A) on this score. This ground is not allowed.
14 In the result, the appeal of the Revenue is partly allowed for statistical purposes and the cross objection of the assessee is dismissed.