ITAT Pune remands transfer pricing adjustment for fresh ALP computation in AE dealings

The Pune Bench of the Income Tax Appellate Tribunal, in the case of Delval Flow Controls Private Limited Vs DCIT, examined the validity of a transfer pricing adjustment sustained in a final assessment order dated 16-01-2017, framed under Section 143(3) read with Section 144C(13) of the Income Tax Act 1961 for Assessment Year 2012-13. The central dispute related to the manner in which the Arm’s Length Price (ALP) was computed for international transactions with Associated Enterprises (AEs), and the characterization of foreign exchange fluctuation gain in the operating results.

The assessee, a manufacturer of industrial valves and related components used in oil, gas and petrochemical sectors, had declared a total income of Rs.4.06 crore and reported several international transactions with AEs. These included:

  • Sale of valves and actuators to AEs
  • Purchase of raw materials from AEs
  • Sale of valves and accessories to AEs

The Assessing Officer (AO) referred the matter to the Transfer Pricing Officer (TPO) for determining the ALP of these international transactions. Although the assessee’s choice of method and comparables was broadly accepted, the computation of the transfer pricing adjustment—and the treatment of foreign exchange fluctuation gain—became the subject of litigation.

Background of the transfer pricing examination

Assessee’s business profile and TP documentation

The assessee was engaged in manufacturing butterfly valves, actuators and ball valves used in specialized industries. In its transfer pricing documentation, the assessee:

  • Adopted the Transactional Net Margin Method (TNMM) as the most appropriate method
  • Used both internal and external comparables under TNMM
  • Filed Form No. 3CEB reporting the international transactions with AEs

The TPO agreed that TNMM was the right method, but did not accept the assessee’s use of internal TNMM, preferring to base the analysis solely on external comparables.

TPO’s selection of comparables and margins

The TPO applied external TNMM and selected six comparable companies. On this basis, the TPO determined:

  • Average Profit Level Indicator (PLI) of comparables (OP/TC) at 16.64%
  • Assessee’s PLI (Operating Profit / Total Cost) at 11.81%

The basic financials, as captured in the TPO’s working, were as under (amounts in lakhs of rupees):

  • Total Sales: Rs.6097.94
    • AE Sales: Rs.1530.98
    • Non-AE Sales: Rs.4566.96
  • Total Cost: Rs.5453.68
  • Profit: Rs.644.26

From these figures, the PLI of the assessee at 11.81% and that of the comparables at 16.64% were derived. On this foundation, the TPO proposed a transfer pricing adjustment, which was then partially modified by the Dispute Resolution Panel (DRP), culminating in a final addition of Rs.1,03,98,000 in the assessment order.

The assessee brought the matter to the Tribunal, restricting its challenge primarily to the quantum and methodology of the transfer pricing adjustment and the treatment of foreign exchange fluctuation gain.

Tribunal’s analysis of the ALP computation

No dispute on core TP parameters

Before the Tribunal, there was consensus on several fundamental aspects of the transfer pricing analysis:

  • TNMM was accepted as the most appropriate method.
  • The rejection of internal TNMM by the TPO was not contested by the assessee.
  • The set of external comparables and their average margin of 16.64% were accepted by both sides.
  • The assessee’s own PLI of 11.81% was also not in issue.

Thus, the controversy narrowed down to how the ALP for AE sales was quantified and how the resultant adjustment was derived.

Error in entity-level ALP approach

The TPO had computed an “arm’s length” amount for the assessee’s operations at the entity level by applying the comparables’ margin to the total cost of the assessee.