Rule 10B of Income Tax Rules provides methodology for computation of ALP.  Under TNMM, ‘net profit’ is used as benchmark for ALP computation. 

During the assessment, the AO may disallow expenditure incurred by the taxpayer on various grounds like they are personal in nature, they are bogus expenditure, etc.  The disallowance of the AO would be on the ground that expenses are not incurred wholly and exclusively for the purpose of the business and are therefore not allowable expenditure.  In some cases, even the taxpayer may suo moto disallow the expenses in tax computation on ground that they are capital in nature, etc.

An issue that arises for consideration is whether such disallowed expenditure is to be excluded from the operating cost of the taxpayer while computing its net profit margin for computing ALP.  These expenses may have no relation/link with the international transactions and can be treated as non-operating in nature.  For example, if an expense is treated as bogus/personal/capital expenses, then such expense is not incurred to earn the operating margin and should be excluded for computing ALP.

This issue has been dealt with in the following decisions.

Case Laws where held that expenses disallowed are to be excluded

Haworth India Pvt Ltd. v DCIT [2011] 11 taxmann.com 76 (Del), [2011] 11 ITR (Trib.) 757 (Del) – The taxpayer is a subsidiary of Haworth Inc, Singapore and is engaged in the business of manufacturing, whole sale trading and installation of furniture. The taxpayer also provided marketing services to its AE.  With regard to marketing and installation support services segment, taxpayer adopted TNMM as the MAM.  

The taxpayer suo moto disallowed certain commission expense relating to marketing and installation support service segment.  The taxpayer recomputed the margin from 1.13% to 9.63% by taking disallowed commission as non-operating.  The TPO did not accept the contention of the taxpayer and included the disallowed expenses in the operating cost.  DRP upheld the TPO’s order.

On Appeal before the ITAT, the taxpayer contended that expenses disallowed for IT purpose cannot form part of operating cost. In the alternative, it was contended that in case expenses are part of operating cost for the purpose of computing ALP, same should also be allowed for the purpose of income tax computation.

The ITAT observed that major component of receipt of international transaction of the taxpayer is commission income as it constituted Rs 15,39,33,769 of the total operating income of Rs 17,73,98,197.  Therefore, the ITAT held that commission expenses, which have been suo motu disallowed by the taxpayer were part of operating expenses while computing the ALP. The ITAT held that if they are subsequently disallowed suo motu by the taxpayer in the revised return, they are required to be excluded from the operating cost and the calculation of the taxpayer should be accepted and its profit margin should be taken according to the income computed in the revised return for which the taxpayer has also paid the due taxes. The ITAT directed to exclude the expense disallowed from the operating cost.

Marubeni India Pvt. Ltd. v DCIT [2012] 15 ITR (Trib) 297 (Del-Trib.), [2012] 144 TTJ (Del) 474 – The AO made a disallowance of Rs 14,40,045 on account of business promotion expenses. The AO disallowed 25 per cent of the total expenses under this head on the ground that element of personal nature is involved.  Before the CIT(A), the taxpayer contended that the disallowed amount should not form part of operating cost while computing ALP. The CIT(A) allowed the claim.  On appeal by Revenue, the ITAT held that once it is held that amount represents expenses of personal nature then it cannot have any bearing on the international transaction. The expenses were therefore to be excluded while computing the operating cost.

Diagno Search Life Sciences Pvt Ltd v ACIT [2016] 69 taxmann.com 294 (Mumbai) – The ITAT held that expenses disallowed should be reduced from operating cost.

Hyundai Motor India Engineering (P.) Ltd. v. ITO [2017] 78 taxmann.com 22 (Hyderabad – Trib.), (2017) TaxCorp (INTL) 11249 (ITAT-HYDERABAD) – The TPO has considered other Finance charges of Rs. 6,31,227/- as ‘operating cost’. It was contended that these charges are in the nature of up- front fees for obtaining loan which was used for capital purposes.  Hence, these expenses should not be considered as operating in nature. The DRP directed the AO to verify from the computation of total income as to whether the above expenses have been disallowed treating the same as capital in nature and if so, directing the AO to reduce the same from the operating cost. The DRP also directed that if it is claimed and allowed as ‘revenue expenditure’, it has to be considered as part of operating cost.  On appeal by Revenue, the ITAT held that there is no need to interfere with the directions of the DRP on the issue.

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