Comparable companies to be selected on the basis of functional comparability. Reasonable adjustments are permissible for better comparability

Executive Summary
The Mumbai bench of the Income Tax Appellate Tribunal (“the Tribunal”) recently pronounced its ruling in case of Firmenich Aromatics (India) Private Ltd (“the taxpayer”), wherein the Tribunal held the following:
 While drawing the comparability analysis, suitable and reasonable adjustment on account of backward
integration, research and development and cost of raw materials should be made.
 TP adjustments should be restricted to the transactions with the Associated Enterprises (“AEs”) only and not to the entire turnover.
 Benefit of +/- 5 percent as per erstwhile proviso to section 92C (2) of the Income Tax Act, 1961 (“Act”) available to the taxpayer.
Facts
The taxpayer, a joint venture company, is engaged in business of manufacturing of industrial fragrances, flavors and chemical specialties which are used for manufacturing of soaps, detergents, cosmetics, toiletries, foods, pharmaceuticals, etc. The international transactions entered into by the taxpayer are import of raw material, export of finished goods and receipt and payment of commission. Transactional Net Margin Method (“TNMM”) was adopted as the Most Appropriate Method (“MAM”) by the taxpayer for benchmarking the international transactions on an aggregate basis, identifying five comparable companies in the Transfer Pricing Study Report.
The arithmetic mean of the Operating Margin (“OM”) of the comparable companies was calculated at 10.19% as against 9.97% earned by the taxpayer at entity level. Accordingly, the taxpayer concluded the international transactions undertaken to be at arm’s length.
During the assessment proceedings, the Transfer Pricing Officer (“TPO”) rejected four out of the five comparable companies on the ground of functional dissimilarity and further identified an additional comparable company, S.H. Kelkar & Co. Ltd while selecting the final comparable companies. Considering the two comparable companies, the TPO computed the OM at 16.085% and accordingly made an adjustment of Rs. 5,13,99,552 on the entire turnover of the taxpayer.
Aggrieved by the order of the TPO, the taxpayer appealed before the Commissioner of Income Tax (Appeals) (“CIT (A)”). The CIT (A), agreed with the taxpayers arguments like differences in age of the company, know- how and technology facility, customer base, product segment, financial and book share value for S. H. Kelkar & Co. Ltd and rejected the same. CIT (A) also examined the comparability analysis of the taxpayer and found merit in arguments of the taxpayer for reliance on the five comparable companies, thereby deleting the entire addition made to the income of taxpayer.
The department, being aggrieved by the CIT (A)’s direction, filed an appeal before the Tribunal.
Ruling of the Tribunal
 Concurred that TNMM is the MAM in the facts and circumstances. The Tribunal found three out of five comparables of the taxpayer functionally comparable and rejected two comparables.
 The Tribunal also accepted S.H. Kelkar & Co. Ltd. as one of the comparable companies. However, Tribunal directed the TPO to make suitable adjustments for differences on account of backward integration, research and development and cost of raw materials while calculating operating profit of S.H. Kelkar & Co. Ltd.
 Adjustments should be restricted to transactions entered with AEs only and would not extend to the entire turnover.
 Benefit of 5% as per erstwhile proviso to Section 92C (2) of the Act was allowed to the taxpayer.
Conclusion
This decision highlights the fact that the taxpayers, in principle, are eligible for suitable adjustments if there are material differences which may affect the Net Profit Margin in the open market. The arm’s length margin is to be applied only to the AE transactions and not on an entire turnover basis.
Source : Deputy Commissioner of Income Tax, Mumbai vs. Firmenich Aromatics (India) Pvt Ltd for AY 2002-2003, ITA No.2056/Mum/2006