TMI Blog2014 (1) TMI 501X X X X Extracts X X X X X X X X Extracts X X X X ..... er authorities, including the Tribunal, misdirected themselves in holding that LFIL assumed substantial risk - LFIL has neither made investment in the plant, inventory, working capital, etc., nor does it claim to have any expertise in the manufacture of garments - LFIL does not bear the enterprise risk for manufacture and export of garments - LFIL’s functional and risk profile thus is entirely different and has nothing to do with the manufacture and export of garments by unrelated third party vendors - LFIL renders support services in relation to the exports, which are manufactured independently - Attributing the costs of such third party manufacture, when LFIL does not engage in that activity, and more importantly, when those costs are clearly not LFIL’s costs, but those of third parties, is clearly impermissible - LFIL has developed experience and expertise which the Tribunal has held to be human capital and supply chain intangibles – But this does not reveal how the assessee borne the risk – either enterprise or economic. LFIL’s remuneration on a cost plus mark-up of 5 per cent represents the functions performed, assets utilized and risks assumed by it - The TPO’s determinati ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... methods, subject to judicial scrutiny. The order of the TPO has not provided any substantive reasons for disregarding the TNM method as applied by LFIL - The TPO’s arbitrary exercise of adjusting the cost plus mark up of 5% on the FOB value of exports finds no mention in the IT Act nor the Rules - Such an exercise of discretion by the TPO, disregarding the LFIL’s lawful tax planning measures with its group companies, is not in compliance with the IT Act and Rules of Income Tax – Decided in favour of assessee. - ITA 306/2012 - - - Dated:- 16-12-2013 - S. Ravindra Bhat And R. V. Easwar,JJ. For the Petitioner : Mr. Porus Kaka, Sr. Advocate with Mr. Neeraj Jain, Mr. Manish Kanth and Mr. Ramit Katyal, Advocates. For the Respondent : Mr. N. P. Sahni, Sr. Standing Counsel and Mr. Ruchesh Sinha, Advocate. JUDGMENT Mr. Justice S. Ravindra Bhat 1. The present appeal under Section 260A of the Income Tax Act, 1961 (hereafter the IT Act ) impugns the order dated 30.09.2011 of the Income Tax Appellate Tribunal, Delhi Branch D , New Delhi (hereafter the Tribunal ) in ITA No. 5156/Del/2010, for the assessment year 2006-07. The present appeal concerns the alleged apporti ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ovider performing limited functions with minimal risk as an offshore provider and substantial functions relating to buying services was performed by the AE, which also assumed various enterprise risks. Thus, the compensation paid to the appellant at cost plus 5% as remuneration was to be considered at arm s length while applying the TNMM. Alternatively, the AE entered into contracts with unrelated third parties for rendering buying services @ 4% to 5% of the FOB value of exports. LFIL had in turn received service fee of Rs.47.69 crores which is equivalent to nearly 4% of the FOB value of the export (by the vendors) from the AE, which constituted 80% of the consideration received by the AE, which, in LFIL s opinion ought to have been considered at arm s length. 5. The Transfer Pricing Officer by an order dated 28.10.09 under Section 92CA(3) of the IT Act did not dispute the selection of the comparable companies for application of TNMM by LFIL. However, he held that the cost plus compensation @ 5% of cost of incurred by LFIL was not at arm s length and applied a mark up of 5% on the FOB value of export of Rs. 1202.96 crores made by the Indian manufacturer to overseas third party cu ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... , to lower cost economies like India to stay competitive and to increase profits. In this case, the AE has recognized that India offers both cost and operational advantage such as tower salaries for the employees, low cost material and low cost manufacture. Accordingly, it has established a trading company in India for procurement of goods. Location savings generally emerge when companies transfer their operation site from high cost economy to economies with low cost. That is, they take advantage of price differences in the factors for production or procurement across the countries. In many cases, the location saving arise from differences of low labour cost, low raw material and finished goods cost, low logistic cost and lower quality control cost. The net location saving represent saving from moving to low cost economy. In this case, the assessee is operating in low cost economy has generated location saving due to huge difference in cost of procurement between high cost economy and low cost economy like India. From a trading pricing prospective the common question in this case is: who is entitled to additional profits in form of locational saving? or which country should tax ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... percentage of FOB of goods sourced through the assessee. (b) The assessee is operating in a low cost country like India and its operating cost is so low that it is a very poor proxy of the value it adds to the sourced goods. (c) The assessee has developed unique intangibles like supply chain management intangibles and Human Asset Intangible which has resulted in huge commercial and strategic advantage to the AE and these intangibles have enhanced the profit potential of the AE. However, these intangibles did not form part of the operating cost. Accordingly, the value addition made by the assessee using intangible, to the FOB value the goods sourced through it remained unremunerated and operating cost plus mark up model does not capture the compensation for value addition made through these intangibles. Accordingly commission should be computed on FOB value of goods. (d) The assessee has generated huge locational saving for the AE as discussion in Para 5.2.5 of this order. However, compensation model based on operating expense of the assessee does not include locational saving attributable to the assessee which could only be capture if commission is calculated on FOB value of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... udice to the above finding that the assessee is a risk bearing entity and does not require any adjustment on account of risk, the claim of the assessee is not admissible on the following grounds: (a) The assessee has not conducted risk analysis either in case of tested party and comparables and has not demonstrated its risk matrix of comparables as different from tested party. (b) No computation of risk adjustment is filed. (c) The onus to support risk adjustment is on the assessee, who has not discharged that onus. ********** ************ 8.1 The assessee has adopted TNMM with a PLI of OP/OC. It may be pointed out that it is not the intention of this order to change the method adopted by the assessee. The method adopted by the assessee is accepted. The only change being made is on the cost base being applied while applying the PLI, chosen by the assessee. It has already been pointed that the costs do not include cost of sales made through the assessee. This being the case, the mark-up of 5% should obviously be calculated on the full FOB value of exports in on Rs.1202.96 Crores. Following the discussion in the preceding paras, the operating income shall be calculated as a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he IT Act computed LFIL s income at Rs 36, 67, 95, 634/- as against the returned income of Rs 3,08,26,448 after making the addition on account of transfer pricing adjustment. The material part of DRP s reasoning is as follows: After going through the functions of the assessee, we find that it has assumed the role of a full risk bearing trader. Therefore, the plea of the assessee that the cost of goods should not be part of the cost base cannot be allowed. The assessee s plea that the Hon ble ITAT and the Delhi High Court, have held that it is eligible for deduction u/s 80-O of the Income Tax Act has no application in the instant case as the decisions were not rendered in the context of setting the arms length price of the assessee s international transactions. International transactions have to be judged at a different level as opposed to transactions covered by the domestic law. The OECD also recognizes the fact that related parties may fashion their transactions in such a manner that may call for looking at the substance of transactions over the form they are given. The relevant portions of the OECD guidelines issued on 22.07.2010 are as below:- 1.67 Associated enterprise ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the discussion on each of the grounds of objections above, the Assessing Officer is directed to complete the assessment as per the draft order forwarded by him to the assessee subject to modification as discussed in Para 3 above. The Assessing Officer may incorporate the reasons given by the Panel at appropriate places in respect of the various objections while passing the final order. He is also directed to append a copy of these directions to the assessment order. The objections of the assessee are disposed of as above. 9. LFIL preferred an appeal to the Tribunal against the assessment order, which by the impugned order dated 30.09.2011, even while accepting that the TNM Method was the appropriate method for calculation, rejected the LFIL s contention that under Rule 10B (1)(e) of the Income Tax Rules ( the Rules ) made no provision for considering the cost incurred by third parties or an unrelated enterprise to compute net profit margin. The Tribunal by its impugned order held that the appellant was performing all critical functions with the help of tangible and unique intangibles as well as supply chain developed, which helped the AE to enhance its business and resulted i ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ted supra and CIT vs. New Poly Pack (P) Ltd., 245 ITR 492, other case laws. In this regard, we hold that the principle of res judicata is not applicable in the incometax proceedings. Each assessment year is a separate unit and what is decided in one year shall not ipso facto apply in the subsequent years. We have gone through the orders passed in the earlier years which has been placed in the paper book at pages 293 to 305 and for all these assessment years starting from 2002-03 to 2004-05, we find that while accepting profit level indicator nothing has been said about the basis on which the compensation has been received by the associated enterprise on the goods exported from India through assessee. As we have already stated earlier, the associated enterprise was receiving the compensation as a percentage of the FOB value of the goods exported through the assessee and as per the guidelines of the OECD which recognizes that the related party may fasten their transaction in such a manner that may call for looking at the substance of transactions over the form they are given. In this case, the associated enterprise was receiving the compensation on the basis of FOB value while the In ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... T vs. Cheil Communication India Pvt. Ltd., cited supra, is not of much help as in that case, the facts were different. In that case, the assessee was providing to their party/media agency for and on behalf of the principal. In that case, the advertising space has been let out to the third party vendor in the name of ultimate customer and the beneficiary of advertisement. The assessee in that case was simply acting as intermediary between ultimate customer and the third party vendor in order to placement of advertisement. In assessee s case, the associated enterprise has been receiving the mark up as 5% of the FOB value of exports effected by assessee by applying its tangible and intangible capacity. The critical and all crucial work is done by assessee. The AE is paying back to the assessee only on the basis of cost plus 5% mark up. Such an arrangement cannot be said at arms length. In our considered view, such method will go against the basic normal business sense, as inefficient and high cost services provided by assessee shall fetch more revenue to the assessee. Such an arrangement on the face of it cannot be said to be at arm s length. The AE is getting remuneration on FOB valu ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ed over the period of time and the developed supply chains of the management owned by assessee benefits the ultimate purchaser and also provide locational savings to the all including the associated enterprise. As we have already said that the amount of adjustment computed by the TPO cannot exceed the amount which could have been received by the associated enterprise. There is nothing on the record from where we could gather that the compensation @ 5% on FOB value received by AE is depressed or on lower side. In view of these facts, we are of the view that the amount of adjustment so computed should not exceed the amount received by the associated enterprise. In our considered view, the AO as well as the DRP has proceeded on a wrong footing which have given absurd results of adjustments. In view of the fact that majority and crucial services rendered by assessee, the distribution of compensation received by AE @ 5% of the FOB value of the exports between the assessee and the associated enterprise should be in the ratio of 80 : 20. The assessee must get 80% of the total receipt by AE from the ultimate purchasers. AO is directed to compute the arm s length price in the above manner. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ayment made by an assessee to third party vendors for and on behalf of the principal (which was reimbursed by the AE), cannot to be included in the total cost for determining the profit margin and the mark up is to be applied to the cost incurred by the appellant company. The value of export by third party vendors to third party customers does not provide any substantial basis for determining the arm s length price 14. Counsel further submitted that the mark up upon the entire FOB value of the AE would artificially enhance the LFIL s cost base for applying the OP/TC margin. He urged that LFIL s compensation model should be based on functions performed by it and the operating costs thereby incurred and not on the cost of goods sourced from third party vendors in India. Thus, allocating a margin of the value of goods sourced by third party customers from exporters/vendors in India is inappropriate and unjustified. 15. Learned senior counsel further argued that in terms of the Transfer Pricing documentation, LFIL had established the international transactions of rendering buying services to be at arm s length price having regard to the operating profit margin earned by comparable ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ncept of locational savings are attributed to the end purchaser only. The TPO by holding that the arm s length prices of international transactions of running, buying/sourcing services by LFIL ought to be 5% of the FOB value of exports, clearly misunderstood the business model and international transactions undertaken by the appellant. The TPO failed to consider the fact that the transaction of export of finished goods is being undertaken by third party vendors or exporters to the overseas customers, whereas neither LFIL nor its AE are parties to such contracts. By providing sourcing support services, none of them have gained any advantage on account of locational saving associated with the export of goods between exporters and overseas customers. Thus, it is submitted that the adjustment made by the TPO on ground of locational saving, is not sustainable and liable to be deleted. 19. The learned counsel also urged that the amount of adjustment computed by the TPO in the order passed cannot exceed the net margin i.e. gross revenue received from the end customers less amount paid to LFIL, i.e. the amount retained by the AE in respect of the transactions. LFIL rendering sourcing ser ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... LFIL, at its cost, but were not reflected adequately in the assessment/price paid for these services by the AE on account of the relationship between the parties. These intangible provided several advantages exclusively to the AE in the form of low cost, quality of the product, strategic and pricing advantage as well as enhanced profitability. Learned counsel submits that LFIL offered cost and operational advantages including lower salaries, low cost material and low manufacturing costs, while the AE, on the other hand, had neither quantified locational saving nor had it attributed any part of its additional profit on account of locational saving to the assessee in India. The assessee, according to counsel, did not show if the AE had any technical capacity or manpower and therefore, LFIL s claim of its involvement in execution of sourcing services could not be accepted. 22. The counsel for the Revenue urged that since the AE was receiving 5% of the FOB value from the purchasers and assessee in performing crucial and critical functions with the use of tangible and unique intangibles developed over a period of time, it is only proper that LFIL must receive the majority of the recei ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... between these competing objectives. Crucially, in India, in balancing these objectives, the precise limits of the methods and mechanics of calculating the arm s length price are provided for by the IT Act and the IT Rules made thereunder, so as to ensure certainty in these calculations rather than roving enquiries. 25. Specifically, the object behind introduction of Chapter X of the IT Act was to prevent assessees from avoiding payment of tax by transferring income yielding assets to non-residents whilst at the same time retaining the power to benefit from such transactions i.e. the income so generated. Under the original 1961 IT Act, a similar provision was found under Section 92. By Finance Act, 2001 w.e.f. 1.4.2002, Section 92 was substituted by Sections 92 to 92F, provisions in Chapter X of the Act. The Central Board of Direct Taxes ( the CBDT ) by its Circular No. 14/2001 dated 12.12.2001 [2001 252 ITR (ST.) 65] spelt out the scope and effect of these provisions The rationale for substituting the existing Section 92 of the IT Act was explained in the following extract of the said Circular: 55.2Under the existing section 92 of the Income Tax Act, which was the only sectio ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s one, which is, directly or indirectly, managed and controlled by another. The one appropriate mode, amongst the several, through which control can be exercised by one enterprise on the other is provided in sub-section (2) of Section 92A. In the eventuality of an enterprise fulfilling any of the attributes provided in sub-clause (a) to clause (m), the two enterprises under Section 92A(2) is deemed to be AE. Section 92B defines as to what would be construed as an international transaction . In order to appreciate the full width, amplitude of an international transaction the meaning of which is provided in section 92B one would have to in addition read the definition of transaction given in Section 92F(v). 27. Section 92C is the provision enabling determination of ALP. Section 92C (1) states that ALP in relation to an international transaction could be determined by any of the methods provided in the said sub-section which is most appropriate having regard to the nature of transactions or class of transaction or class of associated persons or functions performed by such persons or such other relevant factors which may be prescribed by the Board. The methods provided being ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... de by him of the ALP. Section 92CA (3) provides that the TPO, by an order in writing, will determine the ALP in relation to an international transaction in accordance with Section 92C (3) after hearing such evidence as the assessee may produce including any information or documents referred to in Section 92D (3), after considering such evidence as the TPO may require on any specified points, and after taking into account all relevant material which the TPO has gathered. The TPO has to send a copy of the order, by which a determination of ALP is made both to the Assessing Officer and the assessee. Section 92CA (3A) provides the time frame within which the TPO has to pass an order under Section 92CA (3). 29. Prior to the Finance Act, 2007, Section 92CA (4) read as follows: On receipt of the order under sub-section (3), the Assessing Officer shall proceed to compute the total income of the assessee under sub-section (4) of section 92C having regard to the arm s length price determined under sub-section (3) by the Transfer Pricing Officer. 30. It would be useful to recollect that the IT Act draws heavily from the Organization for Economic Co-operation and Development Model Tax ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ly, Rule 10B(1)(e) prescribes, in detail, the steps to be undertaken while applying the TNNM method: first, one must compute the net profit margin of the assessee with the reference to the sales, costs, assets or any other relevant base. The net profit margin from an external (or internal) comparable (as discussed below) is then calculated, which is subsequently adjusted for factors materially affecting profit. This profit margin is then worked out after such adjustments is treated as the actual margin of profit, and added to the cost/other relevant base to arrive at the ALP. 34. The OECD Guidelines, which are instructive in such cases, clarify that any attempt to use TNMM should begin by comparing the net margin which the tested party makes from a controlled transaction with the net margin it makes from an uncontrolled one (an internal comparable ). If this proves impossible, possibly if there are no transactions with uncontrolled parties, then the net margin which would have been made by an independent enterprise in a comparable transaction (an external comparable ) serves as a guide to determine the ALP. Here, the strict criterion is of an independent enterprise, carrying ou ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... r the performance of services themselves. 36. The appellant, during the relevant assessment year, entered into international transactions of buying services for sourcing of garments, handicrafts, leather products etc. in India for its affiliate, the AE, and was paid service charges of 5% of cost plus mark up incurred for providing these services. The assessee had worked out the arm s length of international transaction by applying TNMM by company operating profit margin of 26 companies and assessee s OP/OC taken at 5.17%. 37. The tax authorities i.e. the TPO, and the AO (as well as the DRP) and the Tribunal accepted the application of TNMM by LFIL as the most appropriate one. Nevertheless, they did not consider the cost plus compensation at 5% at arm s length. The reasoning for not doing so was that LFIL was performing all critical functions, assuming significant risks and used both tangibles and intangibles developed by it over a period of time. Reliance was placed upon the technical capacity, manpower, low cost of product, quality of product in India available to the assessee and the enhanced profit potential the AE. The tribunal held that the cost plus 5% mark up is defi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ion that to apply the TNMM, the assessee s net profit margin realized from international transactions had to be calculated only with reference to cost incurred by it, and not by any other entity, either third party vendors or the AE. Textually, and within the bounds of the text must the AO/TPO operate, Rule 10B(1)(e) does not enable consideration or imputation of cost incurred by third parties or unrelated enterprises to compute the assessee s net profit margin for application of the TNMM. Rule 10B(1)(e) recognizes that the net profit margin realized 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 ... (emphasis supplied). It thus contemplates a determination of ALP with reference to the relevant factors (cost, assets, sales etc.) of the enterprise in question, i.e. the assessee, as opposed to the AE or any third party. The textual mandate, thus, is unambiguously clear. 40. The TPO s reasoning to enhance the assessee s cost base by considering the cost of manufacture and export of finished goods, i.e., ready-made garmen ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... clearly not LFIL s costs, but those of third parties, is clearly impermissible. A contrary conclusion would amount to treating it (the appellant) as the vendor/ exporters partner in their manufacturing business a completely unwarranted inference. 43. Indeed, having done the work, LFIL has developed experience and expertise which the Tribunal has held to be human capital and supply chain intangibles. But such description does not in any way reveal how the appellant bears any risk - either enterprise or economic. LFIL s remuneration on a cost plus mark-up of 5 per cent represents the functions performed, assets utilized and risks assumed by it. Further, the TPO s determination that LFIL bore significant risks is not borne out from the records. In transactions in which LFIL was a party, it did not bear any financial risk. To the contrary, its costs towards establishment, transportation, salaries, etc. were fully reimbursed, and it was insulated from any economic or financial downside to any particular transaction. In other words, its remuneration was based entirely on the costs borne by it. In essence, it is a low risk contract service provider exclusively rendering sourcing supp ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... law and travelled outside the Rules. 46. The assessee had argued that no such adjustment was made in the earlier assessment years, for which assessment orders of previous four years were submitted, wherein the TNMM with operating profit over total cost (OP/TC) as a profit level indicator was accepted previously. Reliance was placed on decisions of the Supreme Court in Radhasoami Satsang (supra) and CIT v. New Poly Pack (supra) to support the aforementioned argument. Although previous tax assessments do not bar subsequent claims as res judicata, each assessment must be justified on its own terms, and as detailed above, the assessment by the TPO/AO, and the subsequent acceptance of these methods by the appellate authorities, is inconsistent with the IT Rules and the IT Act. 47. At this point, it is useful to note that the TPO is required to scrutinize the various methods that may be employed to evaluate their appropriateness, the correctness of the data, consideration of surrounding factors, etc. The selection of the most appropriate method will depend upon the facts of the case and factors mentioned in rules contained in Rule 10C. It would be useful here to refer to two circular ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d correct there can be no intervention by the Assessing officer. This made clear by sub section (3) of Section 92C of the Income-tax Act which provides that the Assessing officer may intervene only if he is, on the basis of material or information or document in his possession, of the opinion that the price charged in international transaction has not been determined in accordance with sub section (1) and (2) or information and documents relating to the international transaction have not been kept and are maintained by the assessee in accordance with the provisions contained in sub section (1) of section 92D of the Income-tax Act and the rules made there under; or the information or data used in computation of the Arms length price is not reliable correct; or the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by a notice issued under sub section (3) of section 92D. If any one of such circumstances exists, the Assessing officer may reject the price adopted by the assessee and determine the Arms length Price in accordance with the same rules. 48. The TPO after taking into account all relevant facts and data a ..... X X X X Extracts X X X X X X X X Extracts X X X X
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