Seminal decision: Capacity Utilization Adjustment in Transfer Pricing

The Transactional Net Margin Method (‘TNMM’) is a prescribed method for determining the arm’s length price in some cases. It also enjoins the adjustment owing to capacity under-utilization differences. Sizes of entities and level of activities differ, so does the available comparables for the purpose of transfer pricing adjustments.

The rationale to eliminate capacity under-utilization when applying the TNMM is that the TNMM may be more acceptable than the other prescribed methods under the Income-tax Act, 1961 (‘the Act’) as the differences in the levels of absorption of indirect fixed costs would affect the net profit margin and not the gross margin / gross mark-up on cost.

The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, July 2010, prescribe the making of adjustments to eliminate differences in capacity utilization or idle capacity adjustments. Also, Rule 10B(1)(e)(iii) of the Income-tax Rules, 1962 (‘the Rules’) stipulates that an adjustment to the net profit margin can be made for “capacity under-utilization”.

Capacity under-utilization by enterprises is a factor affecting net profit margin because lower capacity utilization results in higher per unit costs, which, in turn, results in lower profits at a transactional or unit level. There is no debate on the need for adjustments, however the issue is as to the reasonable accuracy in the mechanism for such adjustments; so long as a reasonable adjustment mechanism can be employed, objections to the adjustment won’t hold.

In this context, it is useful to recall the observations of the Hon’ble Delhi High Court in Sony Ericsson Mobile Communication India Pvt. Ltd. [March 2015]: “It must be stated that transfer pricing is not an exact science but a method of legitimate quantification which requires exercise of judgment on the part of the administration and the taxpayer. It is method and formula based and therefore is rational and scientific”. At present there is no authoritative guidance relating to capacity utilization adjustments but the decision of the Delhi Bench of the Income Tax Appellate Tribunal’s (‘the Tribunal’) in the case of Claas India Private Limited [ITA No. 1783/Del/2011], has put forth useful observations and guidelines on capacity utilization adjustment.

The Tribunal noted that the taxpayer had claimed idle capacity adjustment by reducing its own operating costs. The taxpayer, engaged in the manufacture, sale and export of farm equipments, claimed to have worked at a capacity of 29%.

The Transfer Pricing Officer (‘TPO’) concluded 54% as being the average capacity utilization of the comparables chosen by him. Accordingly the TPO applied the factor of 29/54 (29% being the taxpayer’s capacity utilization and 54% being the average capacity utilization of the comparables chosen by the TPO) for reducing the operating costs actually incurred by the taxpayer.

The judgment of the Tribunal states that in case there are some differences between the comparables and the taxpayer, then the effect of such differences should be ironed out by making suitable economic adjustment to the operating profit margin of comparables. The Tribunal held that the correct course of action provided under the law is to adjust the operating costs of the comparable and their resultant operating profit.

Since neither the Act nor the Rules provide the mechanism for computing capacity utilization adjustment, but in this judgment the Tribunal has laid down the following important principles:

• It is essential to ascertain the percentage of capacity utilization by the taxpayer and the comparables when applying the TNMM.
• The difference in the percentage of capacity utilization of the taxpayer vis-à-vis comparables should be given effect to in the operating profit of comparables by adjusting their respective operating costs.

The Tribunal explained that operating costs can be either fixed, variable or semi-variable:

• Semi-variable costs need to be split into fixed and variable part.
• The variable costs and the variable portion of the semi-variable costs remain unaffected due to any under or overutilization of capacity.
• The fixed operating costs and the fixed part of the semi-variable costs are scaled up or down by considering the percentage of capacity utilization by the taxpayer and such comparable.

To illustrate, the Tribunal employed the following example:

Comparable Company Name      ABC Limited

Fixed Cost                                           INR 100

Capacity Utilization                       50%

The Tribunal explained that the taxpayer having capacity utilization of 25% incurs full fixed costs with 25% of the utilization of its capacity, vis-a-vis ABC Limited which incurred full fixed costs at 50% of its capacity utilization. At unit level, this reflects that the taxpayer has incurred relatively more fixed costs, whilst ABC Limited has incurred lower costs.

To improve the quality of comparability, there arises a need to eliminate the effect of this difference in capacity utilization. This can be done by proportionately scaling up the fixed costs incurred by ABC Limited so as to make it fully comparable with the taxpayer.

Hence the need for increasing the fixed costs of ABC Limited to INR 200 [INR 100 x (50/25)] as against the actually incurred fixed costs by it at INR 100. When computing the operating profit of ABC Limited by substituting the fixed cost at INR 200 instead of the actual fixed cost of INR 100, it would mean that the fixed costs incurred by the taxpayer and ABC Limited are at the same capacity utilization.

The Tribunal as regard to capacity utilization re-emphasizes the need for maintaining credible and accurate information for transfer pricing purposes. The decision is indeed welcome and perhaps seminal, addressing the concerns of industry and professionals alike and providing much needed guidance to the Revenue and taxpayers when making capacity utilization adjustments.