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2015 (11) TMI 26 - DELHI HIGH COURT

2015 (11) TMI 26 - DELHI HIGH COURT - [2016] 380 ITR 43 - Transfer pricing adjustment - whether Tribunal erred in replacing the PLI adopted by the Assessee to determine the ALP with another PLI despite not providing any cogent reasons for the same and in fact providing contradictory remarks while rejecting Return on Capital Employed (‘ROCE’) as the PLI? - whether the Revenue was right in rejecting ROCE as a PLI - Held that:- It appears to the Court that the rejection of ROCE as PLI by the Revenu .....

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ernate PLI (i.e. Operating Cost as a percentage of Total Cost excluding raw material cost) is adopted even if the raw material was ordered based on recommendations and a confirmed order by the Assessee’s customer Maruti Udyog Limited - Held that:- In the absence of any reliable comparable data, and in the absence of proper reasons, it would not be justified for the Revenue to simply reject a financial ratio adopted by the Assessee for computing the net profit margin by excluding a pass though co .....

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JMUK there would have been no application of transfer pricing since MUL and JMUK are unrelated entities. MUL would have purchased the PGM just like JMIPL did on negotiated prices. There is merit in the contention that the prices at which JMIPL purchased PGM from JMUK were already at arm’s length and that it was for administrative convenience that MUL had outsourced this function to JMIPL. The submission of the Revenue that the accounting entries of JMUK do not treat the cost of PGM as a pass thr .....

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consideration, the Court finds no reason why for the AY in question, i.e. 2003-04, with no distinguishing features being pointed out, the Revenue would want to reject the alternate PLI adopted by JMIPL.For the above reasons, Question (ii) is answered in the affirmative, i.e in favour of the Assessee and against the Revenue. - ITA 14/2013 - Dated:- 30-10-2015 - S. Muralidhar And Vibhu Bakhru, JJ. For the Appellant : Mr. Vikas Srivastava, Ms. Varsha Bhattacharya and Mr Siddharth Joshi, Advocates .....

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a Private Limited ( JMIPL ) is engaged in the business of manufacture and sale of automobile exhaust catalysts. 90% of the shares of the Assessee Company are held by Johnson Matthey Plc. UK ( JMUK ) through Matthey Finance, BV, Netherlands. JMIPL s manufacturing unit is located at IMT, Manesar in Haryana. Maruti Udyog Limited ( MUL ) is a major customer of JMIPL accounting for most of its sales. 3. JMIPL and MUL agreed on an arrangement where JMIPL would sell finished catalysts to the vendors of .....

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ns on them and then supplied the wash coated substrates to JMIPL. The agreement between JMIPL and MUL 4. JIMPL states that since the prices of precious metals in the market fluctuate heavily, it entered into a Platinum Group Metals ( PGM ) Forward Cover Agreement with MUL on 6th September 2002. Schedule I to the PGM Forward Cover Agreement comprised supplementary terms and conditions of sale. Under Clause 1.1, JMIPL agreed to give a quote to Maruti for the price of a quantity of PGM to be purcha .....

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e of MUL would place a firm and binding order for the PGM with JMIPL by fax within the specified valid period using a form set out in Schedule-2 to the agreement. 5. Schedule-2 was titled PGM Order Form and set out a proforma of the instructions regarding the date of purchase, price of purchase, quantity as well as the type of PGM. Clause 1.4 gave JMIPL the discretion to accept the future order on the terms of the PGL quote by sending a fax notice to MUL. Clause 2 specified of the limits and rat .....

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current procedures which JMIPL has the absolute discretion to change, being set out in Schedule 3. 6. Schedule 3 to the agreement specified 500,000 UK Pounds (UKP) as the upper limit for the value of the future contract that JMIPL could enter into on behalf of Maruti during any one calendar month. The upper limit for the total of all future contracts that could be held by JMIPL on behalf of MUL was specified as 2 million UKP. The terms of payment were set out under Clause 3. Clause 3.1 stated th .....

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of the maturity date of each order, such surplus PGM would become payable by MUL together with interest at the prevailing Bank of India Base Lending Rate. 7. The supplementary terms and conditions of sale were incorporated into the agreement itself. Clause 7 of the Supplementary Terms and Conditions, i.e. Schedule-1 to the agreement, set out the mechanism concerning PGM purchasing and pricing. It read as under: Maruti will provide their requirement for three months. Base on their requirement for .....

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atch would be agreed on the last day of that month. The price for the extra number of pieces supplied would be worked out and the price differential in terms of value would be incorporated in the next month s Quotation i.e. in the month (n+1) and the Purchase order for the same will be raised prior to the commencement of the supplies. 8. JMIPL states that there is a fixed manufacturing charge per unit of catalyst manufactured by it. These charges are determined on the basis of negotiations with .....

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the case to the Transfer Pricing Officer ( TPO ) under Section 92 CA (3) of the Act. 10. JMIPL had submitted a transfer pricing report to the TPO in which it had selected itself as the tested party in order to benchmark the international transaction with its AE. On the basis of functional and risk profile and on examination of the available comparable data, the Transactional Net Margin Method ( TNMM ) was determined to be the most appropriate method for determining the arm s length price ( ALP .....

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he comparable companies came to 18.33% which was less than that of JMIPL, i.e., 28.42%. JMIPL accordingly contended that the international transactions were at arm s length. In order to benchmark the transaction of sale of catalyst to the AEs, JMIPL s net profit margin, i.e., profit after tax as a percentage of sales in relation to export sales was determined as 6.98% and which was higher than the net margin on local sales to unrelated parties (3.73%). JMIPL, therefore, contended that the intern .....

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. In the order dated 22nd March 2006 for AY 2003-04, the TPO discussed the various types of PLIs and how the reliability of each could be enhanced through a number of adjustments for differences in capital employed and functions performed. One method was the Return on Operating Assets ( ROA ) which refers to the return on capital employed. The next method was the Berry Ratio, or Gross Profit measured against Operating Expenses. Analysing Rule 10B(1)(e) of the Income Tax Rules, 1962 ('Rules&# .....

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suitable. Finally, the TPO observed that since JMIPL was engaged in the manufacturing of automobile exhaust catalysts and importing raw materials from its AEs, ROA could not be applied. 14. In the proceedings before the TPO, JMIPL was asked to substantiate its claim that the appropriate PLI was ROCE. JMIPL explained that if the OC was to be taken as a base (i.e. the denominator) then the amount considered should be such sum after the raw material cost ( RMC ) is subtracted from the OC. In other .....

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ustry, it was observed that OP/TC is therefore considered as appropriate PLI. The TPO concluded that: The arithmetic mean of the OP/TC ratio of the comparable companies is 16.85%. Accordingly, on benchmarking the result of the assessee company with that of the comparables, the assessee should have earned a margin of 16.85% over its total cost. In this manner the arm s length price of international transaction undertaken by the assessee with its associated enterprise is calculated as under: Opera .....

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t on an arm s length basis. He re-determined the value of the international transaction at ₹ 62,49,06,744 instead of the reported value of ₹ 70,82,93,603. He recommended an addition of ₹ 8,33,86,859 to the income of JMIPL. Proceedings before the AO, the CIT (A) and ITAT 16. The AO passed the assessment order on 29th March 2006 accepting the order of the TPO and concluding that the difference between the average OP/TC of the comparable companies (16.85%) and that of JMIPL (6.79% .....

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the view that Return on Capital Employed is not an appropriate PLI in the case of appellant and thus the TPO was right in rejecting such PLI. 18. The above order of the CIT (A) was affirmed by the ITAT by its order dated 27th March 2012. It was, inter alia, observed that the accounting of the Assessee shows that the cost of raw material is to be treated as a value added cost and not as a pass through cost. Even the AE which are using the precious metal for manufacturing catalyst raw material and .....

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following questions of law: (i) Whether on the facts and in the circumstances of the case, the Tribunal erred in replacing the PLI adopted by the Assessee to determine the ALP with another PLI despite not providing any cogent reasons for the same and in fact providing contradictory remarks while rejecting Return on Capital Employed ( ROCE ) as the PLI? (ii) Whether on the facts and circumstances of the case, the Tribunal erred in not treating the cost of the raw material as a pass through cost a .....

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ial is prone to price fluctuations. In order to ensure that JMIPL does not lose money on sales if the prices of raw materials increase drastically after the placement of the order, the prices at which such raw materials are to be purchased are frozen. This is an established industrial practice which ensures that both parties do not suffer on account of the frequent fluctuations in the PMG market. He submitted that a manufacturer never purchases and stocks the raw material until and unless there .....

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ROCE was an appropriate PLI. ROCE would be the best indicator of profitability as long as the risks are properly accounted for. In the case of JMIPL for AYs 2002-03 to 2011-12, the Revenue had accepted that it was a contract manufacturer. Therefore any departure from the PLI employed by JMIPL, keeping in line with the guidelines aforementioned, required cogent reasons to be given. Under the economic theory of capital, capital always flowed from low return to high return activities and in time ri .....

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unction was performed by JMIPL, no risk was undertaken and no assets were employed. Therefore, no return could be expected on the raw material purchased by JMIPL. He submitted that the findings of the TPO, CIT(A) and ITAT do not take into account the fact that JMIPL was operating on a fixed manufacturing charge per unit model, being a contract manufacturer. JMIPL's profit margin was dictated by the negotiations with MUL. JMIPL cannot possibly earn a profit based on a percentage of the raw ma .....

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ive convenience that MUL has outsourced its function of purchase of raw material to JMIPL but still controlled every element of such raw material, i.e. quantity, price, mode of purchase (spot/forward) etc. 24. Referring to the sample letter dated 19th March 2002 written by MUL to JMIPL, he submitted that the Assessee purchased raw materials on the specific instructions of MUL. While it was true that the actual catalyst was not sold to MUL but to MUL s vendors, there was no agreement between JMIP .....

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or, should be determined in a manner consistent with the business profile of the enterprise. According to him, the OECD and the US Guidelines as well as the Indian transfer pricing regulations envisaged adjustments to the cost base by excluding i certain items based on the risk profile of an enterprise. Thus, if an enterprise bears no risk in terms of inventory, raw materials etc. and these do not contribute to its returns, such items should be excluded from calculations. If, at all, the PLI of .....

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axman 510 (Del)Mr. Srivasatava submitted that no departure ought to have been made for the AY in question i.e. 2003-04. Submissions of counsel for the Revenue 26. Countering the above submissions, Mr. Kamal Sawhney, learned Senior Standing counsel for the Revenue submitted that the attempt by JMIPL at adopting ROCE as the PLI was contrary to Rule 10 B (1) (e) (i) because assets (or capital employed) had no relationship to the international transactions, which were essentially purchase transactio .....

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of PGM by JMIPL from JMUK was not a pass through transaction since the sale of raw material was not directly made by JMUK to MUL but it was a sale first made to JMIPL which in turn sold it to vendors of MUL. Mr. Sawhney submitted that a true pass through cost would have been where the purchasers of the final product viz. the automotive catalysts would themselves purchased the raw materials, handed it over to JMIPL as a bailee to utilize it in the manufacture of the products and then purchase th .....

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y of JMUK. Referring to the order of the CIT (A) Mr. Sawhney pointed out that the CIT (A) had noted that JMUK at the time of selling the precious metals to JMIPL included it in its turnover and JMIPL included the corresponding purchase in its expenditure side. Once the material was processed and sold to the vendors of MUL, JMIPL included the total sale value in its turnover. Nowhere, did the accounting entries show that the materials purchased were to be treated as a pass through cost. 28. Mr. S .....

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raw material consumption was ₹ 75.85 crores. Out of total raw material consumption, purchase worth ₹ 69.28 crores was from JMUK. Thus if RMC from JMUK was excluded, very little would remain on which net margin could be computed. It was further submitted that JMIPL's argument was unsupported by the provisions of the Act and the Rules. They did not envisage removing any element from the appropriate base. Further, it would be self-contradictory to compute ALP of international trans .....

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cisions of the income tax authorities. Reliance was placed on the decisions in New Jehangir Vakil Mills Co. Ltd. v. CIT (1963) 49 ITR 137 (SC) and ITO v. Murlidhar Bhagwan Das (1964) 52 ITR 335 (SC). Question (i) 30. The first issue that arises for consideration is whether the Revenue was right in rejecting ROCE as a PLI. JMIPL for the AY in question selected TNMM at an entity level. When for AY 2002-2003, it adopted ROCE as the PLI, the Revenue accepted it. But when it did so for the AY in ques .....

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red, or sales effected, or assets employed or to be employed by the enterprise, or having regard to "any other relevant base." This is more or less what para 6.28 of the ICAI Guidelines state. The question that then arises is whether given that the international transaction in question is that of purchase of raw materials by JMPIL from its foreign AE, JMUK, can ROCE be said to be an appropriate PLI? 32. The OECD Guidelines state that where PLI is "a net profit weighted to assets&q .....

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ointed out by the TPO in the instant case, reliability of ROCE as a PLI depends upon the extent to which the composition of assets/capital deployed by the tested party and their valuation is similar to that of comparables. If operating assets reported in balance sheet do not reliably measure the capital employed, ROCE would be less reliable than financial ratios. If the balance sheet does not accurately reflect the average use of capital throughout year, ROCE would be less reliable. 33. JMIPL ap .....

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"The exclusion of cost of raw material in respect of which the Appellant bears no costs or risks presents a very accurate picture of the profit margins of the Appellant. The exclusion of factors which do not affect returns is allowed under all the guidelines mentioned above. This PLI used in AYs 2004-05,2005-06 and 2006-07 was accepted without any objection by tax authorities." 34. Consequently, it appears to the Court that the rejection of ROCE as PLI by the Revenue for the AY in que .....

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o bear out the submission of JMIPL that it is obliged to procure the raw material on instructions of MUL at a price dictated by MUL from the source selected by MUL. JMIPL is entitled to a per unit fixed manufacturing charge over and above the actual cost of the raw material. The submission of JMIPL that entire cost of raw materials comprising of precious metals and substrates is passed on to or recovered from the ultimate customer without any mark up has not been able to be countered b the Reven .....

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owledged in para 2.93 and 2.94 of the OECD Guidelines. Para 2.93 states that the extent to which it would be acceptable "at arm's length to treat a significant portion of the tax payer's costs as pass-through costs to which no profit element is attributed (i.e. costs which are potentially excludable from the denominator of the net profit indicator)" would depend on the extent to which "an independent party in comparable circumstances would agree not to earn a mark-up on pa .....

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oper reasons, it would not be justified for the Revenue to simply reject a financial ratio adopted by the Assessee for computing the net profit margin by excluding a pass though cost from the TC in the denominator. The expression "any other relevant base" occurring in Rule 10 (1) (e) (i) of the Rules is wide enough to encompass a denominator that excludes pass through costs as long it is demonstrated to be at arm's length. 38. It is further importantly pointed out that the very pur .....

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for administrative convenience that MUL had outsourced this function to JMIPL. The submission of the Revenue that the accounting entries of JMUK do not treat the cost of PGM as a pass through cost fails to acknowledge that JMUK is in the business of selling PGM. It does not require to charge JMIPL for processing the raw material i.e. PGM as that is passed on to MUL's vendors and thereby to MUL. The fact that JMIPL is paid a fixed manufacturing charge per unit shows that costs associated with .....

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