Capacity Adjustment
In Transfer Pricing documentation, businesses undertake economic adjustments in case of differences in economic circumstances between controlled and uncontrolled transactions. Manufacturing companies, in their initial phase, effect capacity utilization adjustment where there is material underutilisation of capacity, resulting in under-absorption of fixed overheads and thereby negatively impacting profitability. Some of the approaches to undertake capacity utilization adjustment include:
- Comparables Capacity %: Comparison of company’s capacity utilization with comparable companies, and adjustment of fixed costs based on the differential underutilized capacity. However, from FY 2011-12 (with updates in Revised Schedule VI), disclosure of installed and actual utilization capacity is non-mandatory in the financial statements and hence is challenging to obtain comparable data points.
- Fixed cost / Sales: Tax payers use Fixed cost / sales to demonstrate underutilization of the capacity & effect economic adjustment based on the differential vis-à-vis comparable companies.
- RBI reports: Since 2008, the RBI has been conducting the Order Books, Inventories, and Capacity Utilization Survey (OBICUS) on a quarterly basis, focusing on the manufacturing sector. Certain Tribunals have ruled in favour of the taxpayer, where RBI reports were relied by taxpayer to arrive at average industry utilization and thereby computing capacity adjustment.
- Depreciation to average WDV of Assets: Ratio of depreciation expense to the average WDV of assets as proxy of capacity utilization. Taxpayers adopt this adjustment where WDV method is adopted by the taxpayer, resulting in significant depreciation expense in the initial years vis-à-vis the comparable companies (where SLM method is adopted), and has found favour with some Tribunals.
- Break-even Point (BEP) Analysis: CVP analysis, based on margin of safety and BEP can be used to highlight underutilization. With data availability, regression analysis can be used to quantify the adjustment – a robust statistical approach.
Some key considerations include:
- Robust documentation of business rationale for such adjustment to be included in the TP documentation such as initial phase of setting-up of the taxpayers’ operations, significant shut downs due to uncontrolled economic / technology factors, etc as well as mapping with the characterisation.
- Selection of appropriate approach to effect capacity adjustment based on factors like industry characteristics, business facts & circumstances as well as accuracy of capacity utilisation information. Taxpayers must also bear in mind that approaches adopted for computing capacity adjustments should be robust so that it is palatable at higher appellate levels
