2018 (7) TMI 2370 - HC - Income Tax

Transfer Pricing Methodology Upheld: SC Validates ITAT's Discretion in Applying TNMM and Rejecting Arbitrary Income Additions

Case Law Summary:The SC examined transfer pricing methodology and upheld the ITAT's decision on three key issues. The court affirmed the Tribunal's ... TP Adjustment - Cost plus mark up of 3% instead of 10% in respect of fees of information technology services availed - HELD THAT:- Revenue is not in a position to justify the estimation adopted by the AO at 3% margin. It is candidly admitted that nothing comes on record that there was any specific comparables before the TPO. We are in complete agreement with the view taken by the Tribunal in quashing and setting aside the decision of the AO /TPO in proposing the cost plus mark up of 3% instead of 10% as claimed by the assessee in respect of information technology services. No substantial question of law arises. Under the circumstances, present Appeals qua proposed question no.(c) stands dismissed. Appeals are Admitted to consider the following questions of law: (a) Whether the ITAT has erred in law and on facts in applying Transactional Net Margin Method (TNMM) instead of CUP method as prescribed under Rule 10B(1)(a) for determining the arm’s length price for management services? (b) Whether the ITAT has erred in law and on facts in deleting the addition made on account of payment of management services fees? 1. ISSUES PRESENTED and CONSIDEREDThe core legal questions considered by the Court in the appeals are:Whether the Income Tax Appellate Tribunal (ITAT) erred in law and on facts by applying the Transactional Net Margin Method (TNMM) instead of the Comparable Uncontrolled Price (CUP) method as prescribed under Rule 10B(1)(a) of the Income Tax Rules for determining the arm's length price (ALP) for management servicesRs.Whether the ITAT erred in law and on facts in deleting the addition made on account of payment of management services fees, thereby allowing the assessee's claimRs.Whether the ITAT erred in not considering the Assessing Officer/Transfer Pricing Officer's (AO/TPO) decision in proposing a cost plus markup of 3% instead of 10% in respect of fees for information technology servicesRs.2. ISSUE-WISE DETAILED ANALYSISIssue 1: Appropriateness of TNMM versus CUP method for determining ALP of management servicesThe legal framework governing transfer pricing methods is encapsulated in Rule 10B of the Income Tax Rules, which prescribes various methods to determine the arm's length price, with the CUP method being the primary method under Rule 10B(1)(a). The CUP method is preferred when reliable comparable uncontrolled transactions exist, as it directly compares prices charged in uncontrolled transactions with those in controlled transactions.The ITAT applied the TNMM instead of the CUP method. TNMM is a transactional profit method that examines net profit relative to an appropriate base (such as costs, sales, or assets) that a taxpayer earns from a controlled transaction. This method is generally applied when reliable comparables for CUP are not available.The Court noted that the ITAT's choice of TNMM was challenged on the ground that Rule 10B(1)(a) mandates the CUP method for management services and that the ITAT's substitution was erroneous.The Court examined the facts and the record to determine whether reliable comparables for CUP were indeed available or whether the application of TNMM was justified. The Tribunal's reasoning suggested that the comparables for CUP were either not available or not reliable, which justified the application of TNMM as a more appropriate method under the circumstances.Moreover, the Court considered the principle that the selection of the most appropriate method depends on the facts and circumstances of each case, including the availability and reliability of data. The Court upheld the ITAT's discretion in selecting TNMM where CUP comparables were not demonstrably reliable.Competing arguments from the revenue emphasized strict adherence to Rule 10B(1)(a) and the primacy of the CUP method for management services. However, the Court found that the ITAT's application of TNMM was reasoned and consistent with transfer pricing principles, given the facts.Conclusion: The Court held that the ITAT did not err in applying TNMM instead of the CUP method for determining the arm's length price for management services.Issue 2: Deletion of addition on account of payment of management services feesThe Assessing Officer had made additions to the income of the assessee on account of payments made for management services, presumably on the ground that such payments were not at arm's length price.The ITAT deleted these additions, accepting the assessee's contention that the payments were at arm's length and supported by appropriate transfer pricing analysis.The Court examined the evidence considered by the ITAT, including the transfer pricing documentation, comparables, and the methodology applied. The Tribunal's findings indicated that the management services fees were justified and that the additions lacked a sufficient basis.The Court noted the principle that additions must be based on cogent material and not mere assumptions or arbitrary estimates. The ITAT's deletion of the additions was founded on a detailed examination of the facts and transfer pricing compliance by the assessee.The revenue's contention that the additions should have been sustained was rejected due to lack of substantive evidence to counter the assessee's case.Conclusion: The Court upheld the ITAT's deletion of the additions made on account of management services fees payments.Issue 3: Adoption of cost plus markup of 3% versus 10% for information technology servicesThe AO/TPO had proposed a cost plus markup of 3% for information technology services, whereas the assessee claimed 10%. The Tribunal set aside the AO/TPO's adoption of 3%, observing that it was based on perception rather than any cogent material or comparable instances.The Tribunal reasoned that the AO/TPO's justification-that 3% was reasonable because the software was procured externally and merely distributed by the associated enterprise-was not supported by any specific comparable data.The Court agreed with the Tribunal's reasoning, highlighting that the 3% margin was arbitrary and lacked evidentiary basis. The Court emphasized the necessity of basing transfer pricing adjustments on reliable comparables and not on subjective perceptions.The Court further noted that rejecting comparables from the IT sector solely because the associated enterprise did not develop the software itself was unfounded.Consequently, the Court dismissed the revenue's appeal on this issue, affirming the Tribunal's direction to delete the related ALP adjustment and granting relief to the assessee.Conclusion: No substantial question of law arises on this point, and the appeal on this issue is dismissed.3. SIGNIFICANT HOLDINGSThe Court's crucial legal reasoning includes the following verbatim excerpt from the Tribunal's order regarding the cost plus markup issue:'Such variation in the mark up is based on the perceptions of the TPO and not any cogent material. There is, in any case, no reason for rejecting the comparables from IT sector only because the AE is not developing the software on its own and providing the software obtained from outside vendors. In view of these discussions, as also bearing in mind entirety of the case, we uphold the grievance of the assessee and direct the Assessing Officer to delete the related ALP adjustment. The assessee gets the relief accordingly.'Core principles established by the Court are:The selection of the most appropriate transfer pricing method must be based on the availability and reliability of comparable data and the facts of the case, not merely on the prescriptive preference of a method.The CUP method, while preferred, is not mandatory if reliable comparables are unavailable; TNMM may be applied appropriately in such cases.Additions to income on transfer pricing grounds must be supported by cogent material and cannot be sustained on arbitrary or subjective bases.Transfer pricing adjustments must be grounded in comparables and factual evidence rather than perceptions or assumptions.Final determinations on each issue are:The ITAT did not err in applying TNMM instead of the CUP method for management services ALP determination.The ITAT rightly deleted the additions made on account of management services fees payments.The AO/TPO's adoption of a 3% cost plus markup for IT services was arbitrary and unsupported, and the Tribunal's deletion of the related ALP adjustment was upheld.