(181.3 KiB, 785 DLs)

Despite disclosure of conversion of stock into investment and acceptance by AO, claim that gains is LTCG attracts s. 271(1)(c) penalty

The assessee owned a plot of land which in the earlier years was treated as “stock-in-trade”. In the year of sale, the assessee converted the stock into “investment” and offered the gains as LTCG. The AO accepted the conversion of stock into investment but held that the gains was a STCG as the period of holding had to be reckoned from the date of conversion. This was upheld by all the authorities inclusing the High Court. The AO levied penalty u/s 271(1)(c) which was deleted by the Tribunal on the ground that as the High Court had admitted the assessee’s appeal on the merts, it showed that the issue whether the gain was LTCG or STCG was debatable and could not be treated as frivolous or mala fide to attract the levy of penalty u/s 271 (1) (c). On appeal by the department, HELD reversing the Tribunal:

The Tribunal has side tracked the main issue. It was obvious that conversion of the land into investment just before the sale of the property was made to avoid payment of full taxes. Though the AO accepted the conversion, the assessee’s claim that the gains was a LTCG amounted to furnishing inaccurate particulars of income. The issue was not debatable as held by the Tribunal. Though the appeal was admitted by the High Court, the Tribunal glossed over a very important and fundamental fact that the appeal was admitted and dismissed on the same date. Accordingly, when the order of the AO in quantum proceedings was sustained by all successive authorities and the High Court also dismissed the appeal at the admission stage, albeit after admitting the same, it cannot be said that the issue was debatable.

(352.1 KiB, 1,104 DLs)

S. 147: Despite specific & pointed queries in s. 143(3) assessment, AO cannot be said to have formed any opinion if explicit opinion not recorded

In the balance sheet enclosed with the ROI, the assessee disclosed sundry creditors of Rs. 1.66 crores. In the course of the s. 143 (3) assessment, the AO asked the assessee to submit the entire list of sundry creditors with their names and addresses etc. The assessee submitted confirmations to the extent of Rs. 1.13 crores and though it could not explain Rs. 33 lakhs, the AO assessed only Rs. 19.86 lakhs u/s 41(1) in respect of 7 creditors. The assessee filed an appeal on the issue. After the expiry of 4 years and pursuant to an audit objection, the AO issued a notice u/s 148 seeking to assess the balance of the creditors as well u/s 41(1). The assessee filed a Writ Petition challenging the reopening on the ground that (i) as the AO had consciously assessed only Rs. 19.86 lakhs though he was aware of the creditors’ figure being Rs. 1.66 crores, it was a case of “change of opinion” and (ii) as 4 years from the end of the assessment year had elapsed, reopening was not permissible as there was no failure on the part of the assessee to make a full and true disclosure of the material facts. HELD dismissing the Petition:

(i) The argument that as the AO had called for the details of Rs. 1.66 crores and confined the addition only to Rs. 19.66 lakhs, the reopening is on a “change of opinion” is not acceptable. The question of change of opinion arises when the AO forms an opinion and decides not to make an addition and holds that the assessee is correct. Here, though the AO had asked specific and pointed queries with regard to the sundry creditors of Rs. 1.66 crores, he had made an addition of only Rs.19.86 lakhs and there was no discussion, ground or reason why addition of Rs. 32.97 lakhs was not made in-spite of the assessee’s failure to furnish conformation and details to that extent. The argument that when the assessment order does not record any explicit opinion on the aspects now sought to be examined, it must be presumed that those aspects were present to the mind of the AO and had been held in favour of the assessee is too far-fetched a proposition to merit acceptance (Consolidated Photo vs. ACIT 281 ITR 394 (Del) followed);

(ii) The argument that there was a full and true disclosure of material facts is not acceptable because though in the regular assessment proceedings, the assessee was asked to furnish details with regard to all creditors, this was not done. The term “failure” on the part of the assessee is not restricted only to the income-tax return but extends also to the assessment proceedings. If the assessee does not disclose or furnish to the AO complete and correct information and details it is required and under an obligation to disclose, there is a failure on its part (Honda Siel Power Products vs. DCIT followed).

(176.0 KiB, 848 DLs)

Transfer Pricing: Important principles of “Comparable Uncontrolled Transaction” explained

The assessee, engaged in providing support and advisory services to BP group companies, entered into international transactions with its AEs pursuant to which it made payments for “business support services”. The assessee adopted the TNMM and claimed that the transactions were at ALP on the basis that its profit rate compared favourably with the comparables. In the list of comparables were two entities which had suffered a loss. There were also two other companies with high profit margin. The TPO excluded the loss making companies from the comparables on the ground that they were having a different “functional & product profile” as compared to the assessee. In appeal, the CIT (A) held that the loss making concerns could not be excluded. He also upheld the alternate argument that if the loss making companies were excluded, the high profit companies also had to be excluded. On appeal by the department, HELD reversing the CIT (A):

(i) Under Rule 10B(1)(e)(ii), “the net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transaction is computed having regard to the same base;” The term “uncontrolled transaction” is defined in Rule 10A(a) to mean “a transaction between enterprises other than associate enterprises, whether resident or non-resident”. The result is that in applying the TNMM, the net profit margin realized from a comparable uncontrolled transaction is to be taken into consideration. The conditions require that a case should not only be comparable but also have uncontrolled transactions. These twin conditions need to be cumulatively satisfied. If a case is only comparable but has controlled transactions or vice-versa, it falls outside the ambit of the list of comparable cases;

(ii) Further, Rules 10B (2) & (3) set out the circumstances with reference to which the comparability of an international transaction with an uncontrolled transaction has to be judged. The decisive factors for determining inclusion or exclusion of any case in/from the list of comparables are the specific characteristics of services provided, assets employed, risks assumed, the contractual terms and conditions prevailing including the geographical location and size of the markets, costs of labour and capital in the markets etc. The fact whether the comparable has a higher or lower profit rate has not been prescribed as a determinative factor to make a case incomparable. This is because profit is not a factor in itself, but a consequence of the effect of various factors. Only if the higher or lower profit rate results on account of the effect of factors given in rule 10B (2) read with sub-rule (3), that such case shall merit omission. If however such extreme profit rate is achieved because of factors other than those given in the rule, then such case would continue to find its place in the list of comparables;

(iii) On facts, the two loss making companies, though excluded by the TPO for being functionally different, were not eligible to be taken as comparables because the whole/ majority of the transactions were from related/ controlled parties. The transactions were not “uncontrolled transactions” and so the prescription of Rule 10B (1)(e)(ii) r.w. Rule 10A(a) failed. The alternate argument that if the loss making companies are excluded, the high profit companies should also be excluded is not acceptable. As stated above, the question of inclusion or exclusion from the list of comparables under Rule 10B (2) & (3) has to be determined on the basis of factors like characteristics of services provided, assets employed, risks assumed, contractual terms and conditions prevailing including the geographical location etc and not only on the basis of high or low profit rate (Quark Systems 132 TTJ (Chd) (SB) 1 explained).

(131.4 KiB, 1,471 DLs)

Despite s. 209(3) of the Co’s Act, company can follow cash system for tax purposes

The assessee, a company, followed, in accordance with s. 209(3) of the Companies Act, 1956, the mercantile system of accounting according to which the profits were Rs. 7.48 crores. However, for income-tax purposes, it followed the cash system of accounting according to which the profits were Rs. 4.76 crores and offered that sum to tax. The AO rejected the claim on the ground that u/s 209(3) of the Co’s Act, a company is obliged to follow the mercantile system and that is its’ “regular method” for purposes of s. 145. However, the CIT (A) upheld the assessee’s claim. On appeal by the department, HELD upholding the assessee’s plea:

The assessee has regularly employed the cash system of accounting in recording its day today business transactions. It is not a case where the assessee has been maintaining its accounts of day to day business under the mercantile system of accounting and thereafter prepares accounts in accordance with cash system of accounting for income tax purposes. Section 209(3) of the Companies Act, 1956 does not override s. 145 of the Income-tax Act. There was also no valid basis for the AO’s action in rejecting the books of account and system of accounting followed by the assessee. Further, since the department has accepted the assessee’s system for the past several years, the principles of consistency apply and there should be finality and certainty in litigation in the absence of fresh facts to show that the assessee’s system of accounting is arbitrary or perverse (Amarpali Mercantile 45 ITD 386 (Del) distinguished, Chennai Finance 81 ITD 7 (Hyd) followed).

(171.4 KiB, 1,024 DLs)

Transfer Pricing: Even unrelated parties can be “associated enterprises” if there is “de facto” control. High profit/loss companies are not per se un-comparable. TPO cannot go into issues not specifically referred to him

The Tribunal had to consider the following Transfer Pricing issues (i) whether a “contract bottling unit” (CBU), an unrelated party, manufacturing beverages using the trademarks of the assessee and raw materials purchased from the assessee’s affiliate entities can be treated as the assessee’s “associated enterprise” and the transactions entered into by the CBU with the assessee’s affiliates was an “international transaction” warranting ALP adjustment in the hands of the assessee, (ii) whether comparables with exceptionally high & low profit are required to be excluded even though there are no functional differences between the assessee and such comparables, (iii) whether the TPO could hold that the advertisement expenses incurred by the assessee on brands owned by the AE was excessive (40.64% of turnover) and that the AE should reimburse the excess even though the AO had not made a reference on this issue to the TPO. HELD by the Tribunal:

(i) U/s 92A(1)(a) & (b), if one enterprise controls the decision making of the other or if the decision making of two or more enterprises are controlled by same person, these enterprises are required to be treated as ‘associated enterprises’. Though the expression used in the statute is ‘participation in control or management or capital’, essentially all these three ingredients refer to de facto control on decision making. The assessee had “de facto control” over the CBU as the CBU was wholly dependent on the use of trade-marks in respect of which the assessee had exclusive rights. Further, the entities from which the CBU imported the raw materials were affiliates of the assessee and controlled by the common parent Diageo Plc. Accordingly, the assessee, the CBU and its Diageo group supplier of raw materials were “associated enterprises” as they were de facto controlled, directly or indirectly or through intermediaries, by the same person i.e. Diageo PLC. Further, as the costs incurred by the CBU for purchase of the raw materials was borne by the assessee, the transaction was actually between the assessee and the Diageo group concerns supplying the raw material to the CBU and constituted an “international transaction“;

(ii) The argument, based on Quark Systems 38 SOT 307 (SB), that exceptionally high and low profit making comparables are required to be excluded from the list of TNMM comparables is not acceptable. Merely because an assessee has made high profit or high loss is not sufficient ground for exclusion if there is no lack of functional comparability. While there is some merit in excluding comparables at the top end of the range and at the bottom end of the range as done in the US Transfer Pricing Regulations, this cannot be adopted as a practice in the absence of any provisions to this effect in the Indian TP regulations. (Benefit of +/- 5% adjustment as directed in UE Trade Corporation 44 SOT 457 to be given);

(iii) The adjustment made by the TPO with regard to the advertisement expenditure incurred by the assessee was without jurisdiction because the AO had not made any reference on this issue to the TPO. As the reference to the TPO is transaction specific and not enterprise specific, the TPO Officer has no power to go into a matter which has not been referred to him by the AO. Even the CBDT Instructions are clear on this (3i Infotech Ltd 136 TTJ 641 followed)

(124.9 KiB, 1,087 DLs)

Transfer Pricing: Important Principles of Cost Plus, CUP & TNMM Explained

The assessee, engaged in the business of manufacture and export of studded diamond and gold jewellery, imported & exported diamonds and exported jewellery to associated enterprises. For transfer pricing purposes, the ALP of the imported & exported diamonds was evaluated using the “Comparable Uncontrolled Price” (CUP) method while the exports of jewelry was evaluated using the “Cost Plus Method” (CPM). The TPO & AO rejected both methods on the ground that adequate material to support it was not available and instead adopted the TNMM and made an adjustment. On appeal, the CIT(A) upheld the adoption of CPM on the imports & exports of diamonds on the ground that total cost details were maintained and the average margin earned from AE transactions was higher than that earned from non AE transactions. However, he did not deal with the ALV on export of jewellery. On appeal by the department, HELD reversing the CIT(A):

(i) As regards the CPM, it had not been correctly applied. The application of CPM provides for (a) ascertaining the direct and indirect costs of property transferred, or services rendered, to the AE; (b) ascertaining the normal mark up of profit over aggregate of costs in respect of similar property or services to unrelated enterprises and (c) adjusting the normal mark up for differences, if any, in the material factors such as risk profile, credit period etc. While the benchmark gross profit can be set by taking into account several transactions with unrelated enterprise on a ‘global basis’, the benchmark cannot be applied on a global basis but has to be on a transaction basis. Eg. if the benchmark GP is 20% and the assessee charges a mark-up of 2% in one transaction with AE and 38% in another transaction with the AE, both transactions, will meet the ALP test resulting in an incongruity. On facts, while the normal mark up has been computed at 16.31%, and the average of mark up on sales to AEs has been taken at 17.08% and all AE transactions taken to be at ALP, there are individual instances which are less than the benchmark. This is not the correct way to apply the CPM. Also, the costs of inputs have not been verified and it is not shown that the terms of sale to the AEs and all other relevant factors are materially similar to the transactions with independent enterprises. Also, the CPM has been applied by comparing gross profit on sales, whereas the method requires comparison of mark up on costs on transactions with AEs vis-à-vis mark up on costs on transactions with non AEs (matter remanded to CIT (A) for de novo consideration);

(ii) As regards the CUP for import & export of diamonds (which was not decided by the CIT (A)), the assessee ought to have produced evidence to show that the transactions are at prevailing market prices;

(iii) As regards the TNMM, International transactions with AEs have three significant areas of impact on the overall profitability i.e. sales of finished goods to AEs, sales of raw materials to AEs and purchase of raw materials of AEs), and if the ALP cannot be reasonably determined by CUP or any other direct method (i.e. CPM and RPM) in respect of even one of these areas, the application of TNMM or other indirect method ( i.e. profit split method) is inevitable. On a conceptual note, when ALP of the transactions with AEs cannot be reasonably ascertained, the profit earned by the assessee entering into these transactions is to be estimated, and that is precisely what TNMM does. When TNMM is applied in the context of sales of finished goods to AEs, it is this figure which is taken as variable figure and it bears the impact of higher margins, and when TNMM is applied in the context of purchases of raw materials from AEs, it is the figure of purchases of raw material from AEs which is taken as variable figure and it bears the impact of higher margins. Beyond that, the cause of invoking TNMM does not make much material difference (point whether TNMM has to be applied to the transactions and not on overall profits left open);

(iv) The argument, relying on Indo American Jewellery Ltd 41 SOT 1, that no ALP adjustment can be made as the assessee enjoys s. 10A tax benefits and has no “motive” to avoid tax is not acceptable because those observations are “obiter dicta” without binding force and in view of Aztech Software 107 ITD SB 141 where it was held that tax avoidance motives need not be shown before invoking transfer pricing provisions.

(194.1 KiB, 1,129 DLs)

DRP’s power to “enhance” confined to issues raised in draft assessment order. “Future losses” allowable as deduction

The assessee, a foreign company, declared a loss of Rs. 31.22 crores in its first year of operations after claiming deduction for “Provision for future losses” of Rs. 32.86 crores. The AO passed a draft assessment order u/s 144C in which he disallowed the claim for future losses. The DRP confirmed the disallowance of future losses and also directed the AO to take 20% of the contract as having been completed during the period and to assess 8% thereof as the profit. The assessee filed an appeal claiming that the DRP had no jurisdiction to go beyond the draft assessment order and that the future losses were allowable. HELD upholding the plea:

(i) U/s 144C (5), the DRP can issue directions only in respect of the objections raised by the assessee and the objections are to be in terms of the variation proposed in the draft order. S. 144C (8) restricts the powers of the DRP to “confirm, reduce or enhance the variations proposed in the draft assessment order“. Hence, the DRP’s directions have to be with reference to the objections to the variations proposed in the draft order. In the context of the erstwhile s. 144B, it was held by Courts that the IAC’s review powers were limited to the additions proposed by the AO and that he had no jurisdiction to give instructions which were beyond the purview of the draft order and objections. This principle applies to s. 144C as well. (GE India Technology Centre vs. DRP (Kar) followed);

(ii) As regards the deduction for “future losses“, Accounting Standard AS-7 requires “expected loss” (difference between probable contract costs and contract revenues) to be “recognised as an expense immediately” irrespective of whether work has commenced and the stage of completion of activity. Accordingly, estimated or foreseeable losses are allowable as a deduction. (Jacobs Engineering Private Ltd (ITAT Mumbai) & Mazagaon Dock 29 SOT 356 followed).

(236.4 KiB, 1,234 DLs)

Transfer Pricing & “Cost Contribution Agreements”: Law Explained

The assessee entered into a ‘cost contribution agreement’ with its parent company pursuant to which it paid a sum of Rs. 10.55 crores as its share of the costs. The TPO, AO & DRP disallowed the expenditure on the ground that (i) the ALP was ‘Nil’ as no real services had been availed by the assessee and the arrangement was not genuine, (ii) the cost sharing could not be on the basis of head count but on the basis of actual services availed by the assessee, (iii) the expenditure was “excessive & unreasonable” u/s 40A(2) and (iv) as there was no TDS, the disallowance u/s 40(a)(i) had to be made. The assessee also rendered field services to its associated enterprises where it granted a discount of 10% over the price charged to third parties on the basis that such discount was a part of reciprocal global policy. It was held that the ALP had to be computed by ignoring the discount. On appeal by the assessee, HELD:

(i) The TPO was not entitled to determine the ALP under the cost contribution agreement at “Nil” on the basis that the assessee did not need the services at all. How an assessee conducts his business is entirely his prerogative and it is not for the revenue authorities to decide what is necessary for an assessee and what is not. The TPO went beyond his powers in questioning the commercial wisdom of the assessee’s decision to take benefit of its parent company’s expertise. Further, the TPO’s argument that the assessee did not benefit from the services is irrelevant because whether there is benefit or not has no bearing on the ALP of the services. The fact that similar services may have been granted in the past on gratuitous basis is also irrelevant in determining the ALP. The argument that no evidence of services having been rendered was produced is not acceptable because the assessee did produce voluminous evidence before the DRP which was not dealt with. The DRP ought to have dealt with the material and given reasons. Matter remanded to the AO to determine actual rendering of services (Vodafone Essar Ltd vs. DRP 240 CTR 263 (Del) followed);

(ii) A cost contribution arrangement has to be consistent with the arm’s length principle. The assessee’s share of overall contribution to costs must be consistent with the benefits expected to be received, as an independent enterprise would have assigned to the contribution in hypothetically similar situation. The TPO’s objection that the cost should be shared in the ratio of actual use of services and should be charged as per Indian employee costs is not acceptable. There is no objective way in which the use of services can be measured and as is the commercial practice even in market factors driven situation, the costs are shared in accordance with some objective criterion, including sales revenues and number of employees. The question of charging as per domestic employee costs cannot be a basis of allocating the costs because such an allocation will deal with some hypothetical pricing whereas the allocations are to be done for the actual costs incurred;

(iii) The disallowance of payment under the ‘cost contribution agreement’ u/s 37(1) & 40A(2) is not justified because the payment did not involve mark-up and was at arms length price. The services were for furtherance of the assessee’s business interests;

(iv) The disallowance of payment u/s 40(a)(i) for want of TDS is not justified because the payment was not taxable in the AE’s hands under Article 5 & 12 of the India-USA DTAA as the AE did not have a PE and the services did not constitute “fees for included services”. (GE India Technology Centre 327 ITR 456 (SC) followed);

(v) The TPO’s argument that in charging for the services rendered to the AE, a 10% discount could not be given is not acceptable because (i) the assessee had followed the TNMM for determination of ALP which had not been disputed as the appropriate method, (ii) Even under CUP, all sales need not be at the same price and there can be variations of prices for the same product or services on grounds such as quantum of business, risk factors, etc. Discount is a normal occurrence even in independent business situations. The material factor is whether the 10% discount is an arm’s length discount and there is nothing on record to suggest that it is not so.

(114.1 KiB, 1,843 DLs)

Despite disclosure, legal opinion, favourable CIT(A) order & High Court appeal on merits, s. 271(1)(c) penalty leviable if issue not “debatable” in Tribunal’s view

The assessee, a firm of Chartered Accountants, was one of the “associate members” of Deloitte Haskins & Sells pursuant to which it was entitled to practice in that name. Deloitte desired to merge all the associate members into one firm. As this was not acceptable to the assessee, it withdrew from the membership and received consideration of Rs. 1.15 crores from Deloitte. The said amount was credited to the partners’ capital accounts & claimed to be a non-taxable capital receipt by the assessee. The AO rejected the claim though the CIT (A) accepted it on the ground that it had “great force“. The Tribunal reversed the CIT (A). The AO levied s. 271(1)(c) penalty which the CIT(A) deleted. On appeal by the department to the Tribunal, the assessee argued that penalty was not leviable because (i) there was a disclosure of the facts in the computation & the balance sheet, (ii) the opinion of 3 tax experts had been taken, (iii) the issue was debatable & (iv) the assessee’s appeal on the merits had been admitted by the High Court. HELD allowing the appeal:

(i) S. 271(1)(c) imposes “strict civil liability“. It is not understandable how a CA firm can have any doubt about the receipt being clearly a professional receipt. If it is so, it is not understandable how the assessee can discharge its role as a professional consultant. It is unimaginable that a professional firm will have any doubt on such a simple proposition of professional receipt. The advance tax payment is an indication of the mindset of the assessee;

(ii) The fact that the legal opinions were not furnished during the assessment proceedings (but were furnished only during the CIT(A) penalty proceedings) indicates that the assessee realized the ineffectiveness of these opinions and still ventured into making the non-allowable claim;

(iii) Though there was disclosure in the computation and balance sheet, in order to minimize disclosure, the assessee took the “smart route” of directly crediting the receipt in the capital accounts of partners to evade tax;

(iv) The fact that a substantial question of law on the merits was admitted by High Court does not mean penalty is not leviable (Rupam Mercantiles 91 ITD 237 (Ahd) (TM) not followed);

(210.9 KiB, 2,414 DLs)

S. 40(a)(ia) amendment by FA 2010 is not retrospective

In respect of AY 2005-06, the assessee paid fees to professionals and contractors in respect of which the TDS was deposited after the prescribed due date but before the due date for filing the return of income. The Finance Act, 2010 amended s. 40(a)(ia) w.r.e.f 1.4.2010 to provide that no disallowance would be made if the TDS was deposited on or before the due date for filing the return. The assessee claimed that the said amendment was “remedial and curative in nature” and applicable from AY 2005-06. The issue was referred to a Special Bench. HELD by the Special Bench:

The amendment to s. 40(a)(ia) by the FA 2010 was made retrospectively applicable only from AY 2010-11 and not earlier. It is nowhere stated that the amendment is curative or declaratory in nature nor is such an intention discernible. Ordinarily, a substantive provision is “prospective” in operation and courts cannot give it “retrospective effect” except in limited circumstances where, say, the amendment makes explicit what was earlier implicit or where the amendment was to remove unintended consequences in the existing provison and to make it workable. A provision giving relief cannot be regarded as retrospective only because the original provision caused hardship to the assessee. S. 40(a)(i) caused “intended difficulty” with the object of discouraging non-compliance with the TDS provisions. A partial relaxation in its rigor, inserted with prospective effect, cannot be treated as “retrospective“.