Saturday 10 March 2012

Differences in Working Capital materially affects ALP and requires adjustment for better comparability

Executive Summary
The Pune bench of the Income Tax Appellate Tribunal (“the Tribunal”) recently pronounced its ruling in case of Demag Cranes & Components (India) Private Limited (“the taxpayer”), wherein the Tribunal held the following:
 Taxpayer is entitled to adjustments with regard to working capital adjustment as the working capital differences are likely to affect the arm’s length price of the operating margin of the comparables.
 TP adjustments should be made on Proportionate Basis (i.e. on proportionate sales relating to the impugned international transaction) and not on the entire sales.
 Benefit of +/- 5 percent as per erstwhile proviso to section 92C (2) of the Act available to the taxpayer.
Facts

The taxpayer is a fully owned subsidiary of Demag Cranes & Components GmbH, Germany and is engaged in manufacturing of material handling equipment. The taxpayer has an integrated business involving manufacturing, trading, commissioning and servicing activity. The taxpayer adopted Transactional Net Margin Method (“TNMM”) as the most appropriate method (“MAM”) and benchmarked the international transactions on aggregate identifying six comparable companies in its transfer pricing analysis.
The average profit margin of comparable companies was calculated at 2.76% (using multiple year i.e. F.Y. 2004-05 and 2005-06) as against 11.70% earned by the taxpayer at entity level and thus the taxpayer concluded the international transactions undertaken to be at arm’s length.
During the assessment proceedings, the Transfer Pricing Officer (“TPO”) asked the taxpayer to submit the segment-wise details of the integrated business (Manufacturing, Trading and Servicing segments). The Operating Margin of the taxpayer’s manufacturing segment (2.41%) was compared with the arithmetic mean of the comparables using current year data (7.18%) and the adjustment was proposed to the tune of Rs.1,11,25,670 /-.

The taxpayer was not granted adjustments for expenses relating to higher cost of imports of raw materials and was further deprived from benefit of +/-5%.
The TPO also benchmarked the export of traded components and spares to Associated enterprises (AEs) using Resale Price Method and made adjustments comparing the gross profit margins earned by the taxpayer from dealing with AEs (20.20%) vis-à-vis gross profit margin earned from dealing with third parties (33.62%) and made an adjustment of Rs.8,36,293/-.
Based on the Transfer Pricing order, the Assessing Officer (“AO”) issued draft order by making an addition to the taxpayer’s income which was confirmed by the Dispute Resolution Panel (“DRP”) with minor modifications. The DRP directed the AO to use net margins in place of gross margins to compute arm’s length price for export of components and spares to AEs. The taxpayer was not granted adjustments relating to working capital which was raised for the first time before the DRP.
The taxpayer being aggrieved by the DRP’s direction filed an appeal before the Tribunal.
Ruling of the Tribunal
 The Tribunal stated that working capital constitutes an item of difference in matters of computation of arm’s length price/net margin. Working capital differences are likely to materially affect the arm’s length price / arm’s length operating margin of the comparables and hence should be allowed. The Tribunal in principle relied on several ITAT rulings including Mentor Graphics, E-Gain, etc.,
 In case of higher import cost adjustments, the Tribunal considered the decision of Skoda Auto India and set aside the issue to the files of the AO with direction to examine the claim of the assessee relating to the import cost factor and eliminate the difference, if any, which is likely to materially affect the price/profit in the open market as per Rule 10B(3) of the Income Tax Rules.
 Benefit of 5% as per erstwhile proviso to section 92C (2) of the Act was allowed to the taxpayer. In granting the +/-5% benefit, the Tribunal has relied on earlier decisions of the Pune Bench in case of Cummin India & Starnet Networks.
 The Tribunal agreed with the taxpayer’s contention that computation of TP adjustments should be made on proportionate basis (i.e. proportionate sales relating to the impugned international transaction) and not on the entire sales. The Tribunal relied on various decision including Emersons Process, T Two International, IL Jin Electronics etc. for approving the principle of proportionality in determining ALP.
Conclusion
This decision highlights the fact that the taxpayers, in principle, are eligible for working capital and other adjustments (including import cost adjustment) if there is any difference and which is likely to materially affect the Net Profit Margin in open market. Further, the arm’s length margin at best be applied only to the proportionate sales (i.e. proportionate sales relating to the impugned international transaction) and not on the entire sales. The +/- 5% benefit is to be allowed as per erstwhile proviso to section 92C(2) of the Act.
Source: Demag Cranes & Components (India) Private Limited vs. Deputy Commissioner of Income Tax (ITA No.120/PN/2011) AY 2006-07, Pune Bench of the Tribunal dated 4 January 2012

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