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Joint Commissioner of Income Tax OSD Room No.216-A, Aayakar Bhavan, M.K.Road, Mumbai-400020 Vs. M/s Kiara Jewellery P.Ltd.,Mumbai-400096
May, 09th 2014
                    ,                  "        "  
      IN THE INCOME TAX APPELLATE TRIBUNAL "K" BENCH, MUMBAI

        BEFORE S/SHRI P.M.JAGTAP (AM) AND VIVEK VARMA, (JM)
         .. ,      ,      

                     ./I.T.A.No.8109/Mum/2011
                   (   / Assessment Year: 2007-08)

    Joint Commissioner of Income /            M/s Kiara Jewellery P.Ltd.,
    Tax ­ Circle 8(2),OSD         Vs.         Unit No.180 SDF-VI,
    Room No.216-A,                            Seepz SEZ,
    Aayakar Bhavan,                           Andheri (E),
    M.K.Road,                                 Mumbai-400096
    Mumbai-400020
         . /   . /PAN/GIR                    No. :    AAACK4789M
         ( /Appellant)           ..           (    / Respondent)

                   Cross-Objection No.228/Mum/2012 in
                     ./I.T.A.No.8109/Mum/2011
                   (   / Assessment Year:2007-08)

   M/s Kiara Jewellery P.Ltd.,       /        Dy. Commissioner of Income Tax ­
   Unit No.180 SDF-VI,               Vs.      Circle 8(2), OSD,
   Seepz SEZ,                                 Room No.216-A,
   Andheri (E),                               Aayakar Bhavan,
   Mumbai-400096                              M.K.Road,
                                              Mumbai-400020

    /Appellant)                               (    / Respondent)



            / Revenue by                :    Shri Vivek Batra
              /Assessee by                   Shri I M Contractor


                / Date of Hearing
                                                   : 3.4.2014
             /Date of Pronouncement : 7. 5.2014

                                   / O R D E R

PER P.M.JAGTAP,AM:

      This appeal filed by the Revenue is directed against the order of ld. CIT(A)-15,

Mumbai dated 19.9.2011 and the same is being disposed off along with the Cross-

objection filed by assessee being CO No. 228/Mum/2012.
                                                                      I.T.A.No.8109/Mum/2011
                                             2               Cross-Objection No.228/Mum/2012



2.     The solitary common issue       arising out of this appeal of the revenue and the

cross-objection of the assessee relates to         the Transfer Pricing adjustment of

Rs.1,01,06,805/- made by the Assessing Officer/ Transfer Pricing Officer (TPO) which

has been partly sustained by the ld. CIT(A).





3.     The assessee in the present case is joint venture company of Saphire Products

SA, Switzerland and Shreruj and Company Limited India. It is engaged in the business

of manufacturing of diamonds and precious stones studded jewellery.          The return of

income for the year under consideration was filed by it      on 22.10.2007 declaring loss

of Rs.88,24,570/-. During the course of assessment proceedings, it was noticed by AO

from the transfer pricing study report submitted by the assessee that the assessee has

entered into     various international transactions with its Associated Enterprises (AE)

including transactions        involving export of studded jewellery to its AE worth

Rs.12,77,59,946/-.     He, therefore, made a reference u/s 92CA(1) of the Income Tax

Act, 1961 (the Act) to the TPO for determining the Arm's length price of the said

international transactions.     During the course of proceedings before him, the       TPO

found that the average profit margins (OP/OC) of the comparable selected was 5.31%

as against the    OP/OC of the assessee shown at         (-2.48%).    In this regard, the

explanation offered by the assessee before the TPO was that it was operating at 50%

of its actual capacity during the year under consideration and therefore its operating

profit margin was lower as compared to all the comparables selected.        It was pointed

out that the capacity utilization of the comparables companies for the year consideration

was not available in the public domain and if the same would be taken at 75% and

suitable   adjustment is made to the profit margin on account of capacity utilization,

the adjusted profit margin of the assessee would be 0.93% as against average profit

margin of the comparable         companies   of 5.31%.      It was also claimed that the

difference between these profit margins being less than 5%, no TP adjustment was

required to be made in the case of assessee as per proviso to Section 92C(2) of the Act.
                                                                    I.T.A.No.8109/Mum/2011
                                            3              Cross-Objection No.228/Mum/2012



The adjustment claimed by the assessee on account of capacity utilization was not

allowed by TPO by raising certain doubts about the fixed cost claimed by the assessee.

He also did not allow the claim of the assessee for the benefit of ±5% adjustment

holding that such benefit could be allowed only when the difference between the profit

margin of the assessee and the profit margin of the comparables is within the range

of ±5%. Accordingly, taking the average profit margin of 5.31% of the comparable

companies as Arm's length profit, TP adjustment of Rs.1,01,06,805/- was worked out

by the TPO in his order passed u/s 92CA(3) of the Act.


4.     When addition on account of the TP adjustment of Rs.1,01,06,805/- worked out

by the TPO was made by AO to the total income of the assessee in his assessment

order passed u/s 143(3) of the Act, appeal was preferred by the assessee before the

ld. CIT(A) challenging the said addition.

5.     During the proceedings before the ld. CIT(A), following submissions were made

on behalf of the assessee:


       "(i)     That it being a new company and as it was entering a new market it was
       important that the product had to be of superior workmanship and design to be
       accepted by the customers. Like any other new company, the appellant also
       had a lot of teething problems where the product would need to be modified to
       suit the French market which is very fashion and quality conscious. In fact, the
       representatives of the AE used to visit for checking the quality on a regular
       basis. There were quite a few times when the products had to be re-
       made/repaired after the quality check. To add to it, insufficient orders and
       stringent market conditions resulted in the appellant company's inability to make
       the benefit of the economies of scale as the factory was operating much below
       100% of the installed capacity. The actual production was only 55,629/- pieces
       in financial year (FY) 2006-07) under consideration as compared to 153,938
       pieces, 152,536 pieces, 137,746 pieces in FYs 2007-08, 2008-09 and 2009-10
       respectively. The manpower was employed commensurate with the installed
       capacity as they had to be trained and therefore, it incurred high manpower
       cost and fixed overheads which led to high production cost. In view of it being
       only the second year of operations, re-making cots having been incurred, under
       utilization of capacity, high manpower costs and fixed overheads, etc, the
       appellant had incurred loss during the FY relevant to the assessment year under
       consideration;

       (i)    That, however, the later years the appellant company has managed to
       achieve break-even point in terms of sales and has gotten up to par in terms of
                                                                      I.T.A.No.8109/Mum/2011
                                            4                Cross-Objection No.228/Mum/2012



       quality. This fact also reflects from the financial performance of the appellant
       company in later years ; in FY 2008-09, the PBIT of the appellant has increased
       to Rs.68.01 lakhs and in FY 2009-10 it has further increased to Rs.214.64 lakhs.

       (ii)   That as the appellant, being a new company in the jewellery market in
       France, it was very important for the appellant to ensure that its products were
       of superior craftsmanship and it designs were acceptable to the customers and
       accordingly there was a lot of reworking/remaking involved to ensure that the
       products meet the specified quality standards. Further, the appellant was not
       operating at its full installed capacity and could not absorb its entire fixed costs.
       Thus, in view of it being in the initial phase of business operations, it had
       incurred loss.

       (iii)   That in view of the above abnormal phase of its business and large fixed
       costs sitting in the books of account, and in order to bring out the correct
       picture of its operational activities, it is necessary to make certain economic
       adjustments to certain costs while determining the operating margin of the
       appellant. The appellant submits that certain expenses, such case, lease rent
       charges, rates and taxes and water charges, processing charges, employee cost,
       miscellaneous expenses and depreciation would be considered as fixed cost
       because there are no material or significant changes in these expenses in the
       future years i.e. FY 2006-07, 2007-08 and 2008-09 as compared to the actual
       production of jewelry in terms of units produced in each of these three years ."


6.     After considering the submissions made on behalf         of the assessee as well as

material available on record, the ld. CIT(A) upheld the action of the AO in disallowing

the assessee's claim for adjustment on account of        capacity utilization holding that

although these factors might have contributed to the loss of the assessee company, it

could not be arrived at     with any degree of certainty that the transfer price of the

international transaction have contributed towards the loss of the assessee company

in the absence of any details furnished by the assessee company regarding the price at

which the final product was sold by the AE.           The claim of the assessee qua the

benefit of ±5% adjustment as per second proviso to section 92C(2) of the Act, however,

was allowed by the ld. CIT(A) keeping in view the various case laws cited on behalf of

the assessee.    Aggrieved by the order of ld. CIT(A), the revenue has preferred this

appeal before the Tribunal disputing the benefit of ±5% adjustment allowed by ld.

CIT(A) while the assessee has also filed the cross-objection challenging the order of the

ld. CIT(A) confirming the action of AO/TPO in not allowing its claim for adjustment on

account of capacity utilization.
                                                                       I.T.A.No.8109/Mum/2011
                                             5                Cross-Objection No.228/Mum/2012




7.     We have heard the arguments of both the sides and also perused the material

available on record. As regards the issue involved in the appeal of the revenue relating

to the benefit of ±5% adjustment allowed by ld.         CIT(A) as per proviso to section

92C(2) of the Act, it is observed that the same is squarely covered in favour of the

assessee inter alia by the following decisions of the Tribunal :

a)     Amdocs Business Services (P) Ltd V/s DCIT in
       IT Appeal No.1412 (Pune) of 2011 dated July 23,2012 (AY-2007-08);
b)     Starent Networks (India) P.Ltd V/s DCIT in ITA No.1350/PN/2010, (AY-2006-07)
       order dated 3.10.2011;
c)    Tata Vectra Motors Ltd V/s DCIT in IT Appeal No.1284(Bang) of 2010
       dated January 31,2012 (AY-2006-07)
d)     M/s iPolicy Network Pvt Ltd V/s ITO in ITA No.5504/Del/2010 (AY-2006-07)
      dated 17.6.2011.

8.     In one of the decisions rendered in the case of Starent Networks (India) P.Ltd

(supra), the Tribunal has considered and discussed all the relevant         aspects of the

matter, while allowing the claim of the assessee for the benefits of ±5% adjustment as

per the proviso to section 92C(2) of the Act as prevalent at the relevant point of time,

in paras 20 to 23 of the order which read as under :


       "20. We have carefully considered the rival submissions. In this case, a
       pertinent issue which has been vehemently agitated by the appellant is
       with regard to its claim of seeking benefit of the option available under
       the erstwhile proviso to section 92C(2) of the Act. The erstwhile proviso
       which was inserted by Finance Act, 2002 with effect from 1.4.2002 read
       as under:

               "Provided that where more than one price is determined by the
               most appropriate method, the arm's length price shall be taken to
               be the arithmetical mean of such prices, or, at the option of the
               assessee, a price which may vary from the arithmetical mean by an
               amount not exceeding five percent of such arithmetical mean."

       As per the said Proviso, an option is available to the assessee for
       adjustment of +/-5% variation for the purposes of computing ALP. As per
       the Proviso, where more than one price is determined by the most
       appropriate method, the arm's length price shall be taken to be the
       arithmetical mean of such prices or at the option of the assessee, a price
       which may vary from the arithmetical mean by an amount not exceeding
       5% of such arithmetical mean. The point made out by the assessee is
       based on the latter part of the Proviso whereby an option is given to the
                                                         I.T.A.No.8109/Mum/2011
                                 6              Cross-Objection No.228/Mum/2012



assessee to take an ALP which may vary from the arithmetical mean by an
amount not exceeding 5% of such arithmetical mean. Firstly, the claim of
the Revenue is that such benefit is not available to the present assessee,
because the price of international transaction disclosed by the assessee
exceeds the margin provided in the Proviso. This aspect of the
controversy, in our view, is no longer germane in view of the plethora of
decisions of our co-ordinate Benches, namely, Sony India (P) Ltd. (supra);
Electrobug Technologies Ltd. (supra), and Development Consultant P Ltd
v DCIT 115 TTJ 577 (Kol.) wherein it has been observed that the benefit
of the option contained in the latter part of the Proviso to section 92C(2)
is available to all assessees, irrespective of the fact that price of the
international transaction disclosed by them exceeds the margin prescribed
in the Proviso.

21. So, however, the other argument set up by the Revenue and which
has been more potently argued is to the effect that the benefit of such
Proviso is not available to the assessee in the instant case, because the
said Proviso has been amended by the Finance (No 2) Act, 2009 with
effect from 1.10.2009 which reads as under:

      "Provided that where more than one price is determined by the
      most appropriate method, the arm's length price shall be taken to
      be the arithmetical mean of such prices: Provided further that if the
      variation between the arm's length price so determined and price at
      which the international transaction has actually been undertaken
      does not exceed five per cent of the latter, the price at which the
      international transaction has actually been undertaken shall be
      deemed to be the arm's length price."




The case set up by the Revenue is that the amended Proviso shall govern
the determination of ALP in the present case, inasmuch as the amended
provisions were on statute when the proceedings were carried on by the
Transfer Pricing Officer (TPO). As per the Revenue, the amended Proviso
would have a retrospective operation and in any case, would be applicable
to the proceedings which are pending before the TPO on insertion of the
amended Proviso, which has been inserted by the Finance (No. 2) Act,
2009 with effect from 1.10.2009 and, in this case, the TPO has passed his
order on 30.10.2009. The learned Departmental Representative has also
referred to the CBDT Circular No 5/2010 (supra) read with Corrigendum
dated 30.9.2010 issued by the CBDT in this regard. Per contra, the stand
of the assessee is that the amended Proviso would be applicable
prospectively and would not apply in respect of the stated assessment
year, which is prior to the insertion of the amended Proviso with effect
from 1.10.2009.

22. We have carefully examined the rival stands on this aspect. The
amended Proviso has been brought on the statute by the Finance (No. 2)
Act, 2009 with effect from 1.10.2009. The Explanatory Notes to the
provisions of Finance (No 2) Act, 2009 contained in circular No 5 of 2010
                                                            I.T.A.No.8109/Mum/2011
                                   7               Cross-Objection No.228/Mum/2012



(supra) provides the objective behind the amendment of the Proviso. The
Legislature noticed the conflicting interpretation of the erstwhile proviso
by the assessee and the income-tax Department. The assessee's view was
that the arithmetical mean should be adjusted by 5% to arrive at ALP,
whereas the departmental view was that no such adjustment is required
to be made if the variation between the transfer price and the arithmetical
mean is more than 5% of the arithmetical mean. With a view to resolving
this controversy, the Legislature sought to amend the proviso to section
92C(2), which has been reproduced by us in the earlier part of this order.
In the said Circular, it has also been elaborated that the above
amendment has been made applicable with effect from 1.4.2009 and will
accordingly apply in respect of assessment year 2009-10 and subsequent
years. In any case, the Proviso contains a prescription to determine the
ALP and quite clearly it is a substantive provision encompassing the
eventual determination of an assessee's tax liability. Thus, it can be said
that the Proviso is not a procedural piece of legislation and therefore,
unless it is so clearly intended, the newly amended proviso cannot be
understood to be retrospective in nature. In fact, it is a well-settled
proposition that the statutory provisions as they stand on the first day of
April of the assessment year must apply to the assessment of the year
and the modification of the provisions during the pendency of assessment
would not generally prejudice the rights of the assessee. Furthermore, we
are fortified by the intention of the Legislature as found from circular No 5
of 2010 (supra) whereby in para 37.5, the applicability of the above
amendment has been stated to be with effect from 1.4.2009 so as to
apply in respect of assessment year 2009-10 and subsequent years. In
this regard, we also find that the Delhi Bench of the Tribunal in the case
of ACIT v UE Trade Corporation India (P) Ltd. vide ITA No 4405(Del)/2009
dt 24.12.2010 has observed that the proviso inserted by the Finance (No
2) Act, 2009 would not apply to an assessment year prior to its insertion.
In this view of the matter, we therefore find no justification to deny the
benefit of +/-5% to the assessee in terms of the erstwhile Proviso for the
purposes of computing the ALP.

23. However, before parting we may also refer to a Corrigendum dated
30.9.2010 by the CBDT by way of which para 37.5 of the circular No
5/2010 (supra) has been sought to be modified. The Corrigendum reads
as under: 16

      " CORRIGENDUM

      In partial modification of Circular No. 5/2010 dated 03.6.2010,

       (i) In para 37.5 of the said Circular, for the lines st

      "the above amendment has been made applicable with effect from
      1 April, 2009 and will accordingly apply in respect of assessment
      year 2009-10 and subsequent years."
                                                          I.T.A.No.8109/Mum/2011
                                 8               Cross-Objection No.228/Mum/2012



      the following lines shall be read;

      "the above amendment has been made applicable with effect from
      1 October, 2009 and shall accordingly apply in relation to all cases
      in which proceedings re pending before the Transfer Pricing Officer
      (TPO) on or after such date."

      (ii) In para 38.3, for the date "1 October, 2009, the following date
      shall be read: "1 April, 2009".

In terms thereof, it is canvassed that the amended proviso has been made
applicable with effect from 1.10.2009 and shall apply even to cases where
proceedings were pending before the TPO on or after such date,
irrespective of the assessment year involved and, therefore, in the instant
case the benefit of the erstwhile proviso cannot be extended to the
assessee. We have carefully pondered over the assertion made by the
appellant that the Corrigendum is untenable in the eyes of law. Firstly, the
said corrigendum does not bring out any preamble so as to throw light on
the circumstances and the background in which the same has been
issued. Secondly, it is well understood that the Explanatory Notes to the
provisions of a Finance Act passed by the Parliament seeks to explain the
substance of the provisions of the Act as intended by the Legislature. In
fact, the Hon'ble Supreme Court in the case of K.P Varghese v ITO 131
ITR 597 (Ker) emphasized the sanctity of the statements contained in the
Explanatory Notes of the provisions and stated that the interpretation
placed in such documents is binding interpretation of law. The contents of
the Corrigendum are quite inexplicable. Notwithstanding the aforesaid and
without going into the validity of the Corrigendum dated 30.9.2010
(supra), we are of the view that the same would not operate to the
detriment of the assessee since at the relevant point of time the contents
of the Circular No 5/2010 (supra) were in operation. In other words, the
withdrawal of the interpretation placed in circular No 5 /2010 (supra) on
the applicability of the amended proviso is sought to be done away by the
Corrigendum dated 30.9.2010 and, therefore, such withdrawal shall be
effective only after 30.9.2010, even if such Corrigendum is accepted as
valid. We may note here that the appellant has assailed the validity of the
Corrigendum itself on which we have not made any determination.
Therefore, the Corrigendum dated 30.9.2010, in our considered opinion,
has no bearing so as to dis-entitle the assessee from its claim of the
benefit of +/-5% in terms of the erstwhile proviso to section 92C(2) of the
Act. In coming to the aforesaid, we have been guided by the parity of
reasoning laid down in the judgments of the Hon'ble Bombay High Court
in the cases of BASF (India) Ltd. v CIT 280 ITR 136 (Bom); Shakti Raj
Films Distributors v CIT 213 ITR 20 (Bom); and, Unit Trust of India &
Anrs. v ITO 249 ITR 612 (Bom). The Hon'ble High Court has opined in the
case of BASF (India) Ltd. (supra) that the circulars which are in force
during the relevant period are to be applied and the subsequent circulars
either withdrawing or modifying the earlier circulars have no application.
Moreover, the circulars in the nature of concession can be withdrawn
                                                                      I.T.A.No.8109/Mum/2011
                                             9               Cross-Objection No.228/Mum/2012



        prospectively only as held by the Hon'ble Supreme Court in the case of
        State Bank of Travancore v CIT 50 CTR 102 (SC). Considering all these
        aspects, we therefore find no justification in the action of the lower
        authorities in disentitling the assessee from its claim for the benefit of +/-
        5% to compute ALP in terms of the erstwhile proviso to section 92C(2) of
        the Act. We order accordingly."

9.      On the above lines, the Tribunal in other cases also has decided a similar issue

in favour of the assessee while allowing the benefit of ±5% to the assessee as per the

erstwhile proviso to 92C of the Act. The issue involved in the present case in Revenue's

appeal thus is squarely covered in favour of the assessee by these decisions of the

Tribunal and respectfully following      the same, we uphold the order of ld.        CIT(A)

allowing the benefit of ±5% adjustment to the assessee while computing the               TP

adjustment.

10.     As regards the issue     involved in the cross-objection filed by the assessee

relating to the claim of the assessee for adjustment on account of capacity utilization, it

is observed that the said claim of the assessee was disallowed by    the AO as well as by

ld. CIT(A) on account of irrelevant consideration. In the case of DCIT V/s Petro

Araldite (P) Ltd, the Co-ordinate Bench of the Tribunal has decided the similar issue

vide its order dated July 24, 2013 passed in IT Appeal No.3782 (Mum) of 2011 (AY

2005-06), after considering and discussing the necessity of allowing adjustment on

account of capacity utilization while computing the TP adjustment. The Tribunal has

explained how such adjustment is necessary depending on the facts and circumstances

of the case and has also laid down the guidelines as to how to quantify such

adjustment.    The observations recorded by the Tribunal in this context in paras 19 to

25 of its order are reproduced below :


      "19. There being difference in the capacity utilization of the assessee vis-à-
      vis the comparables, adjustment on account of capacity utilization was
      claimed by the assessee. According to the assessee, if the profit margin is
      taken before depreciation by adopting Earning Before Depreciation, Interest
      and Tax (EBDIT) as PLI, the effect of difference in capacity utilization on
      profit margin can be nullified. The TPO did not approve this method adopted
                                                             I.T.A.No.8109/Mum/2011
                                    10              Cross-Objection No.228/Mum/2012



by the assessee for making adjustment on account of capacity utilization
whereas the ld. CIT(A) found the same to be acceptable holding that the
under utilization of capacity results in under recovery of fixed expenses like
depreciation and if the depreciation is excluded, the effect of difference in
capacity utilization on profit margin can be nullified. Before we proceed to
deal with the issue of adjustment for difference in capacity utilization, it is
necessary first to see the procedure laid down for carrying out the exercise
of comparability analysis and making suitable adjustments. This procedure
as laid down in section 92-C of the Act provides that the ALP in relation to an
international transaction shall be determined by any of the methods
specified therein, being the most appropriate method and the manner in
which the said ALP has to be determined is given in section 92-C(2) of the
Act read with Rule 10B of the Income Tax Rules, 1962 in respect of each
method separately. Clause (e) of Rule 10-B stipulates the manner in which
the ALP in relation to an international transaction is to be determined by
following the transactional net margin method as under:--

         "(e) transactional net margin method, by which,--

        (i) the net profit margin realised by the enterprise from an
            international transaction entered into with an associated
            enterprise is computed in relation to costs incurred or sales
            effected or assets employed or to be employed by the
            enterprise or having regard to any other relevant base;

       (ii) the net profit margin realised by the enterprise or by an
            unrelated enterprise from a comparable uncontrolled
            transaction or a number of such transactions is computed
            having regard to the same base;
       (iii) the net profit margin referred to in sub-clause (ii) arising in
             comparable uncontrolled transactions is adjusted to take into
             account the differences, if any, between the international
             transaction and the comparable uncontrolled transactions, or
             between the enterprises entering into such transactions, which
             could materially affect the amount of net profit margin in the
             open market;
       (iv) The net profit margin realised by the enterprise and referred to
            in sub-clause (i) is established to be the same as the net profit
            margin referred to in sub-clause (iii);

       (v) The net profit margin thus established is then taken into
           account to arrive at an arm's length price in relation to the
           international transaction;"
  20. Keeping in view the aforesaid provisions of the relevant Rule, we can
  now endeavor to consider how and to what extent the difference in
  capacity utilization affects the profit margin and how the adjustment on
  account of difference in capacity utilization can appropriately be made
  within the framework of Rule 10B. The issue of difference in capacity
                                                                 I.T.A.No.8109/Mum/2011
                                     11                 Cross-Objection No.228/Mum/2012



utilisation generally comes in the case of manufacturing concern and like
any other business undertaking, the manufacturing concern has mainly
two types of overheads i.e. fixed overheads and variable overheads. The
variable overheads vary in proportion to the sales and they therefore do
not have any effect on the profit margin as a result of difference in
capacity utilization. The fixed overheads, on the other hand, do not vary
with the volume of sales and since they remain by and large static
irrespective of level of capacity utilization, the profit margin gets affected
as a result of difference in capacity utilization on this count. The under
utilization of capacity results in over allocation or over absorption of fixed
overheads resulting into under-recovery of fixed overheads which
adversely affects the profit margin. As the level of capacity utilization goes
up, the rate of allocation or absorption of fixed overheads to sales comes
down resulting into higher profit margin. The following simple example
would further explain this position:

Installed capacity in monetary terms Rs.10 crores Rs. 10 crores Rs. 10 crores
Capacity utilisation                      50%          60%            80%
Sales                               Rs. 5 crores    Rs. 6 crores   Rs.8 crores
Variable overheads at 50%           Rs.2.5 crores   Rs.3 crores    Rs. 4 crores
Fixed overheads                      Rs.2 crores    Rs. 2 crores   Rs. 2 crores
Net profit                          Rs.0.5 crores   Rs. 1 crore    Rs. 2 crores
Profit margin (OP/Sales)                  10%         16.67%          25%


21. The above example shows that the profitability changes with the
change in the level of capacity utilization with higher profitability at higher
utilization and lower profitability at lower realization. This happens mainly
because of higher allocation or absorption of fixed overheads at lower
capacity utilization which comes down as the level of capacity utilization
goes up. For instance, as given in the above example, the rate of
allocation or absorption of fixed overheads to sales is 40% at 50%
capacity utilization while it becomes 33.33% at 60% capacity utilization
and 25% at 80% capacity utilization giving more profit margin of 16.67%
at 60% capacity utilization and 25% at 80% capacity utilization as against
profit margin of 10% at 50% capacity utilization. The difference in
capacity utilization thus materially affects the profit margin and if there is
a difference in the level of capacity utilization of the assessee and the
level of capacity utilization of the comparable companies, adjustment is
required to be made to the profit margin of the comparables on account
of difference in capacity utilization as per clause (e)(iii) of sub-rule (1) of
Rule 10-B of the Income Tax Rules, 1962.

22. Having held that the adjustment is required to be made to the net
margin of the comparables on account of difference in capacity utilisation,
the next issue that arises is regarding the adoption of proper method by
which the same can appropriately be made. In the present case, the
assessee made this adjustment by not considering depreciation for
                                                            I.T.A.No.8109/Mum/2011
                                   12              Cross-Objection No.228/Mum/2012



computing its own operating profit as well as the operating profit of
comparable. It was done by taking EBDIT as PLI instead of EBIT.
Although this method adopted by the assessee was not approved by the
TPO, it was accepted by the ld. CIT(A) on the ground that the effect of
difference in capacity utilization on profitability could be nullified by taking
EBDIT as PLI instead of EBIT. We are unable to concur with this view of
the ld. CIT(A). In our opinion, when the PLI is taken as OP to sales or OP
to cost, operating profit of the assessee as well as comparable cases
becomes relevant and the depreciation being very much integral part of
the operating expenses of the manufacturing concern, the same cannot
be excluded for the purpose of computing operating profit. Moreover,
clause (e)(i) of sub Rule (1) of Rule 10-B requires that the net profit
margin of the assessee is to be worked out while clause (e)(ii) of the said
sub Rule requires that net profit margin of the comparables is worked out.
Clause (e)(iii), which permits the adjustments, clearly stipulates that any
adjustment on account of differences affecting materially the profitability
is to be made to the net profit margin of the comparables as referred to in
clause (e)(ii). By taking the net profit margin of the assessee without
considering the depreciation in order to make adjustment on account of
difference in capacity utilization, what the assessee has sought to do is to
make adjustment to the net profit margin of the assessee as referred to in
clause (e)(i) of sub Rule (1) of Rule 10B, which in our opinion, is not
permissible in accordance with clause (e)(iii) of sub Rule (1) of Rule 10B.
23. The question that now arises is what is the proper method of making
adjustment for difference in capacity utilization within the frame work
given in Rule 10B. As already discussed by us, the difference in capacity
utilization affects the profitability mainly because of the difference in rates
at which the fixed overheads are absorbed or allocated depending on the
level of capacity utilization. The example given by us clearly depicts this
position. The said example shows that the allocation of fixed overheads at
the capacity utilization of 50%, 60% & 80% is 40%, 33.33% & 25%
respectively resulting in the profit margin of 10%, 16.67% and 25%. In
our opinion, if the fixed overheads allocation or absorption of comparable
is brought at the level of the assessee , it would nullify the effect of
difference in capacity utilization on the profit margin. For example, if we
take the profitability working at 50% capacity utilization as that of the
tested party and at capacity utilization of 60% and 80% as that of the
comparables and adjust the rate of allocation of fixed overheads of the
comparables in order to bring the same at par (i.e. 40% of sales) with the
tested party, the resultant position will be as under:-

Net profit                                      Rs.1 crore      Rs. 2.00 crores

Less additional allocation of depreciation      Rs. 0.40 crores Rs.1.20 crores
by taking the rate of fixed overheads at
40% of sales:
Net profit after adjustment                     Rs. 0.60 crores Rs. 0.80 crores

Profit margin after adjustment                  10%             10%
                                                                      I.T.A.No.8109/Mum/2011
                                            13               Cross-Objection No.228/Mum/2012




        24. The adjustment thus can be made to the profit margin of the
        comparables by allocating fixed overheads at the same rate at which fixed
        overheads are allocated in the case of the tested party. For example, in
        the case of a comparable having 80% capacity utilization, the rate of
        allocation of depreciation is 25% of the sales as against the rate of
        allocation of fixed overheads of 40% in the case of the tested party. If the
        adjustment is made in the profit margin of the said comparables by
        allocating more fixed overheads at 15% of sales to bring the rate of
        allocation of fixed overheads at par with that of the tested party, the profit
        of the comparable would be reduced by Rs. 1.20 crores thereby giving a
        net profit of Rs. 0.80 crores which would bring the profitability to 10%,
        i.e. at par with the tested party. Similarly, if the adjustment is made in the
        profit margin of a comparable having 60% capacity utilization by
        allocating more fixed overheads at 6.67% of sales to bring the rate of
        allocation of fixed overheads at par with that of the tested party, the profit
        of the said comparable would be reduced by Rs. 0.40 crores thereby
        giving a net profit of Rs. 0.60 crores which would bring the profitability to
        10% i.e. at part with the tested party.


        25. Having held that the adjustment on account of difference in capacity
        utilization is required to be made and having explained with illustration
        that the same can appropriately be made by absorbing or allocating fixed
        overheads such as depreciation on sales of the comparable at the same
        rate as that of the tested party, we are of the view that such absorption
        or allocations of fixed overheads on operating cost instead of sales would
        be more appropriate as the same will eliminate the effect of difference in
        profit margin or difference in level of stock of finished goods, if any, of the
        tested party and comparables.

11.     Keeping in view the decision of the Tribunal in the case of Petro Araldite (P) Ltd

(supra) laying down the guidelines on the issue of capacity utilization, we consider it

appropriate to restore this issue     relating to   adjustment on account of capacity

utilization in the case of assessee company to the file of AO/TPO for deciding the

same afresh keeping in view the said guidelines.        If the exact details of capacity

utilization   of the comparable companies are not available in the public domain, the

AO/TPO is directed to obtain the      same directly from the concerned parties and to

decide this issue afresh after giving assessee an opportunity of being heard.
                                                                      I.T.A.No.8109/Mum/2011
                                            14               Cross-Objection No.228/Mum/2012



12.    In the result, appeal of the revenue is dismissed while cross-objection of the

assessee is treated as allowed for statistical purposes.

       Order pronounced in the open court on 7th May, 2014

                                                     7th     May, 2014    

               Sd                                                     sd

     (  /VIVEK VARMA)                                      (.. / P.M.JAGTAP)
     / JUDICIAL MEMBER                                  / ACCOUNTANT MEMBER
  Mumbai:
                    on this 7th      th day of May, 2014

. ../ SRL , Sr. PS
        /Copy of the Order forwarded to :
1.  / The Appellant /Applicant
2.  / The Respondent.
3.      () / The CIT(A)-
4.       / CIT
5.       ,     ,         /
      DR, ITAT, Mumbai
6.      / Guard file.
                                                                    / BY ORDER,
               True copy
                                                             (Asstt. Registrar)
                                            ,   /ITAT, Mumbai

 
 
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