2015 Supreme(Del) 653

HIGH COURT OF DELHI
S. RAVINDRA BHAT & R.K. GAUBA, JJ.
Chryscapital Investment Advisors (India) (P.) Ltd. – Appellant
Versus
Deputy Commissioner of Income-tax – Respondent
IT Appeal No. 417 of 2014
Decided On : 27-04-2015

Headnote:

The Court held that the mere fact that an entity makes high/extremely high profits/losses does not, ipso facto, lead to its exclusion from the list of comparables for the purposes of determination of ALP. In such circumstances, an enquiry under Rule 10B(3) ought to be carried out, to determine as to whether the material differences between the assessee and the said entity can be eliminated. Unless such differences cannot be eliminated, the entity should be included as a comparable.

Fact of the Case:

The assessee is a private limited company incorporated under the Companies Act, 1956 and is engaged in providing investment advisory services, which were reimbursed on a cost-plus mark-up basis. Ashish Dhawan and Kunal Shroff, in the concerned assessment year, were its two shareholders - holding shares in the assessee in the proportion of 2:l; they were also its full time employees. In AY 2008-09, the assessee entered into international transactions with associated enterprises (AEs) relating to advisory services and reimbursement of expenses incurred on behalf of AEs amounting to Rs. 56,61,99,829/- and Rs. 4,49,72,912/- respectively. For the purposes of determination of arm's length price (ALP), the assessee used the Transactional Net Margin Method ("TNMM"). The assessee treated the transactions relating to reimbursement received by it from its associated enterprises on actual basis (i.e. without mark-up) at ALP as such since no value addition was done by it in relation to the said expenses. The assessee identified four entities which were engaged broadly in the same economic activities as in its case and identified as comparables. The result of the arm's length analysis is given below: S.No. Comparable Entity Operating Profit Margins 1. IDFC Investment Advisors Limited - -55.50% 2. Future Capital Holdings Limited - 0.88% 3. Khandwala Securities Limited 43.35% 42.62% - 42.99% 4. Sumedha Fiscal Services Limited -16.47% -20.36% - -18.42%   Final Average 4.04% The assessee's position was that because of fluctuation in the operating profit margins of the comparable entities, multiple year data of the comparables was warranted to remove the effect of year specific aberrations. Against the average Operating Profit Margin ("Operating Margin") of 4.04% earned by the comparable entities, the assessee earned an Operating Margin of 27.05% and concluded that its transactions with its AEs were at arm's length. The assessee relied on Rule 10B(4) of the Income Tax Rules, 1962 (hereafter "the Rules"). Rule 10B(4) reads as follows: "(4) The data to be used in analysing the comparability of an uncontrolled transaction with an international transaction or a specified domestic transaction shall be the data relating to the financial year in which the international transaction or the specified domestic transaction has been entered into: Provided that data relating to a period not being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared."

Finding of the Court:

The Court held that the assessee was incorrect, both in its reliance placed upon previous years' data as well as the manner of such reliance. First, the assessee's justification for relying on such data is the volatility in the comparables' profit margins and the consequent inability to transact at a consistent ALP. However, this is not warranted herein. Whilst there may be a wide fluctuation in the profit margins of comparables from year-to-year, this by itself does not justify the need to take into account previous years' profit margins. The transfer pricing mechanism provided in the Act and the Rules prescribes that while determining the ALP, the arithmetic mean of all comparables is to be adopted. This is to offset the consequence of any extreme margins that comparables may have and arrive at a balanced price. Similarly, the wide fluctuations in profit margins of the same entity on a year-to-year basis would be offset by taking the arithmetic mean of all comparables for the assessment year in question. In any case, in the event that the volatility is on account of a materially different aspect incapable of being accounted for, the analysis under would Rule 10B(3) would exclude such an entity from being considered as a comparable. Secondly, as regards the manner of using previous years' data, the assessee has taken the arithmetic mean of the comparables' profit margins for the assessment year in question and two previous years. This Court disagrees. The proviso to Rule 10B(4), read with the sub-rule, itself indicates that the purpose for which previous years' data may be considered is - analysing the comparability of an uncontrolled transaction with an international transaction. It does not prescribe that once an uncontrolled transaction has been held to be a 'comparable', in order to obviate an apparent volatility in the data, the arithmetic mean of three years (the assessment year in question and two previous years') may be taken. That would amount to assigning equal weight to the data for each of the three years, which is against the mandate of Rule 10B(4). The use of the word 'shall' in Rule 10B(4) and, noticeably, 'may' in the proviso, implies that the relevant assessment year's data is of primary consideration, as opposed to previous years' data.

Issues: 1. Whether the proviso to Rule 10B(4) of the Income Tax Rules, 1962 will be applicable in case of fluctuations in the operating profit margins of comparable companies during the relevant financial year under question as compared to earlier years? 2. Whether comparables can be rejected on the ground that they have exceptionally high profit margins as compared to the assessee in transfer pricing analysis? 3. Whether factors like differential functional and risk profile coupled with high degree of volatility in operating profit margins is (sufficient ground to reject comparables for transfer pricing analysis? 4. Whether disallowances can be made under Section 36(1)(ii) when the bonus paid to shareholders is not in the exact proportion of their shareholding and there is no avoidance of taxes?

Ratio Decidendi: The Court held that the mere fact that an entity makes high/extremely high profits/losses does not, ipso facto, lead to its exclusion from the list of comparables for the purposes of determination of ALP. In such circumstances, an enquiry under Rule 10B(3) ought to be carried out, to determine as to whether the material differences between the assessee and the said entity can be eliminated. Unless such differences cannot be eliminated, the entity should be included as a comparable.

Final Decision: The appeal is accordingly partly allowed, in the above terms. No costs.