The Delhi High Court in its recent judgment has ruled that for the purpose of ALP, mere fact of super profits/losses does not, ipso facto, lead to its exclusion from the list of comparables unless there are material differences which can not be eliminated. Also As a general rule, it is not open to the assessee to rely upon previous year‟s data

Details of the Case:
Income Tax Appeal No.: 417/2014
Chryscapital Investment Advisors (India) Pvt. Ltd...Appellant  Vs Dy. Commissioner of Income Tax. …..Respondents
Assessment Year: 2008-09
Coram: Hon'ble Mr. Justice S. Ravindra Bhat, Hon'ble Mr. Justice R.K. Gauba

Date of Judgment:  27-04-2015

Question of Law involved:
(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?

Facts of the Case:
The basic question before the Court was if there is a concept of “super profit” in the arm‟s length price/transfer price determining process under the Income Tax Act which entitle tax administrators to include high profit.

The assessee was a private limited company providing investment advisory services, which were reimbursed on a cost-plus mark-up basis. 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. The Transactional Net Margin Method (TNMM) was used for determination of arm’s length price (ALP) and transactions was treated on actual basis without mark-up.

The assessee company identified four entities as comparables engaged broadly in the same economic activities. Assessee company took average of three years data of the comparables on the ground of the fluctuation in their margins.  The average Operating Profit Margin of comparable entities were quite low as compared to the assessee company and thus the assessee relying on rule 10B(4) of the Income Tax Rules, 1962 concluded that its transactions with its AEs were at arm‟s length. The assessee argued that using multiple year data is consistent with the OECD Guidelines as well as transfer pricing regulations of several developed jurisdictions. The Operating Margin of the assessee was stable in contrast to the comparable companies.

The matter was referred to the Transfer Pricing Officer (TPO) under Section 92CA (3). TPO concluded that multiple year data for the assessee‟s comparables could not be used but introduced two new comparables with abnormal business profits. The TPO also retained a comparable inspite of it showing abnormal growth in the assessment year under consideration and considered reimbursable expenses as part of operating expenses and corresponding reimbursement as part of operating revenue of the assessee for the purpose of determining the arm's length price.

The three new entities selected by TPO as comparables had very high profit margins as compared with that of the assessee. Those entities namely, Brescon Corporate Advisors Limited (Brescon) (Operating Margin 87.4%), Keynote Corporate Services Limited (Keynote) (Operating Margin 191.58%) and Khandwala Securities Limited (Khandwala) (Operating Margin 80.79%) had exceptional profit margins called “super profits” as compared with the Assessee company (Operating Margin 27.05%)

The Assessing Officer  passed the order as per the recommendation of TPO and also disallowed the bonus paid by the assessee to its shareholder employees under Section 36(l)(ii).

Before the High Court, the assessee contended that the entities earning “super normal” or “abnormal” profits should be excluded from the list of comparables .

The High Court after a detailed analysis of the judgments, findings and rationale of various benches of ITAT on the subject observed that he many decisions of different benches of the ITAT indicate a rote repetition. The court compared it to the “lazy repetition” as per the words of Felix Frankfurter J, as under:

"A phrase begins life as a literary expression; its felicity leads to its lazy repetition; and repetition soon establishes it as a legal formula, undiscriminatingly used to express different and sometimes contradictory ideas".   Justice Felix Frankfurter in Tiller v. Atlantic Coast Line Railroad Co. , 318 U.S. 54 (1943)

The Delhi High Court Concluded as under:

a. 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.
b. While determining the comparability of transactions, multiple year data can only be included in the manner provided in Rule 10B(4). As a general rule, it is not open to the assessee to rely upon previous year‟s data.
c. As regards Khandwala Securities and Brescon, the matter is remitted to the DRP to carry out the analysis under Rule 10B(3) and determine whether the material differences arising out of their exceptionally high profits can be eliminated. If not, the said entities cannot be included as comparables. For Keynote, firstly, enquiry is to be carried out by the DRP, preceding the analysis under Rule 10B(3), as to its functional similarity with the assessee; thereafter, the exercise of determining if there are material differences on account of exceptionally high profits which are capable of elimination has to be carried out.
d. The deduction claimed by the assessee under Section 36(1)(ii) of the Act, in respect of the bonuses paid to its shareholder-employees is allowed.

The High Court  remitted the matter for consideration to the Dispute Resolution Panel (DRP) to properly apply the test indicated in this judgment and analyse the functional similarity of comparables with the assessee and directed that in the event DRP finding them to be functionally comparable, it would proceed to carry out the Rule 10B(3) analysis as in the case of Khandwala Securities and Brescon.

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