TMI Blog2014 (2) TMI 1230X X X X Extracts X X X X X X X X Extracts X X X X ..... of the TPO in rejecting the methodology adopted by the assessee to calculate net sales for the purposes of computing the royalty payable. TPO considering 5% rate of royalty payment on export sales as arm’s length price as against 8% paid by the assessee - Held that:- We hold that the TPO erred in (i) re-working the stated value of the international transaction of royalty payment based on his interpretation of the expression ‘Net Sales’ and, (ii) considering the royalty payment by TNAPC to the AE as a comparable transaction under the CUP method for the purposes of determining the arm’s length price of the international transaction of royalty payment claimed by the assessee. As a consequence the adjustment/addition of ₹ 91,66,061/- made in respect of royalty payment is directed to be deleted. Addition on account of the international transaction on export of a product namely, Trigonox 25C75 to the AE - Held that:- The adjusted price of ₹ 300/- per kg., in our view, is liable to be taken as an arm’s length price in respect of export of Trigonox 25C75 to the AE instead of the stated price of ₹ 239/- per kg.. As a result, the addition of ₹ 11,34,000/- made ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ity with the directions given by the Dispute Resolution Panel, Pune (in short the DRP ) dated 30.09.2010. 3. In this appeal, Grounds of Appeal raised by the assessee read as under: -. On the fact and circumstances of the case, and in law; 1. The Ld. Assessing Officer ('AO'), pursuant to the directions given by the Ld. Dispute Resolution Panel ('DRP'), erred in ruling that the transactions pertaining to royalty payment, export of certain finished goods and provision of marketing and sales support services have not been conducted at arm's length, and thereby making a transfer pricing adjustment of ₹ 11,475,285 to the income of the appellant. In the process, the Ld. DRP/AO erred in: For royalty payments: considering the controlled royalty rate (prevailing between two of the appellant's Group companies) as a comparable to the rate of royalty at which the appellant paid royalty to its associated enterprises ('AE'), for benchmarking purpose under the comparable uncontrolled price ( CUP ) method. holding that the royalty amount (in connection with provision of technology) needs to computed by deducting the cost of ra ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... analysis by the Transfer Pricing Officer (in short TPO ), as a consequence of a reference made by the Assessing Officer in terms of section 92CA(1) of the Act. The TPO vide his order u/s 92CA(3) dated 08.10.2009 proposed an addition of ₹ 1,14,75,285/- towards transfer pricing adjustment to the stated values of the international transactions undertaken with the AEs. The Assessing Officer has thereafter passed order u/s 143(3) r.w.s.144C(13) of the Act dated 25.11.2010 making an addition of ₹ 1,14,75,285/- in conformity with the order of the TPO dated 08.10.2009 and also in accordance with the directions of the DRP contained in its order dated 30.09.2010, who was approached by the assessee raising objections against the draft assessment order proposed by the Assessing officer on 08.10.2009. The aforesaid addition of ₹ 1,14,75,285/- made to the returned income is the subject-matter of dispute in the present proceedings. 5. Before we proceed to adjudicate4 the specific objections raised in the Grounds of Appeal, the background of the dispute can be summarized as follows. In the course of proceedings before the TPO, it was noticed that the assessee had entered into ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nst 8%, claimed by the assessee. Thus, for the aforesaid reasons, total adjustment in respect of royalty was determined at ₹ 91,66,061/-. Thirdly, the TPO determined adjustment in respect of other segment i.e. Marketing and Sales support Segment of ₹ 11,75,224/-. As a result, the total adjustment on account of the transfer pricing analysis of the aforestated international transactions was determined by the TPO at ₹ 1,14,75,285/-, and accordingly the Assessing Officer, being bound by the directions of the TPO as per section 92CA(4) of the Act in respect to the determination of arm s length price, enhanced the returned income of the assessee by the said sum. The aforesaid action of the Assessing Officer, based on transfer pricing adjustment of ₹ 1,14,75,285/- determined by the TPO, is the subject-matter of dispute before us, in terms of the stated Grounds of Appeal. 6. In the above background, the rival counsels have been heard. The appellant has furnished voluminous Paper Books which inter-alia contain the submissions and material furnished to the lower authorities, and the same has been referred during the course of hearing. The learned CIT(DR) has also r ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... TPO, royalty has been calculated by the assessee in excess of what is otherwise warranted. Secondly, as per the TPO, the royalty paid to the AE for export sales @ 8% is not at an arm s length price for reason that royalty paid by another Akzo group company i.e. Tianjin Akzo Nobel Peroxides, China (hereinafter referred to as TANPC ) to 7th e same AE was @ 5%; and, therefore the TPO adopted the rate of 5% to determine the arm s length royalty payable by assessee to the AE on the export sales. The aforesaid position has since been affirmed by the DRP also. 8. On both the aforesaid aspects, the learned counsel for the assessee vehemently submitted that the lower authorities have erred in law as well on facts. Firstly, it is contended that the expression Net Sales , was required to be interpreted in terms of the standard terms and conditions prescribed by the Reserve Bank of India, which are applicable to all agreements pertaining to royalty payments on technology transfers to Indian companies. In this regard, our attention was drawn to the meaning of expression Net Sales provided in para 3.3 of Chapter III of the Manual for Foreign Direct Investment Policy Procedures issued by ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t between the Chinese entity TANPC and the AE, copies of which have been placed in the Paper Book at pages 376 to 386 of the Paper Book for assessment year 2006-07 and at page 186 of the Paper Book for assessment year 2007-08 respectively. In this context, it is sought to be made out that the period of the agreement and the products covered are different inasmuch as the Indian agreement is for seven (7) years whereas the China s agreement is for twenty (20) years. The products covered under the two agreements are also different inasmuch as the Indian agreement has 22 products whereas China s agreement has 33 products. It is submitted that where the period and the products covered are different, such transactions cannot be considered as comparable and reference has been made to the decision of the Pune Bench of the Tribunal in the case of Kirloskar Ebara Pumps Ltd. 47 SOT 20 (Pune) in this regard. Thirdly, it is sought to be made out that there is an error in the addition made on account of royalty inasmuch as a sum of ₹ 3,07,170/- h9a s been added in excess, even if the stand of the TPO was liable to be upheld. 10. On the other hand, the learned CIT(DR) appearing for the R ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... on royalty payment by TANPC to its AE @ 5% was a perfect comparable while applying the CUP method and thus the action of the TPO is sought to be justified. 11. We have carefully considered the rival submissions on this aspect. Before proceeding to adjudicate the addition of ₹ 91,66,061/- made on account of royalty payment, it would be relevant to note the pertinent facts. The appellant company is paying royalty to the AE for transfer of technology in terms of a Foreign Technology Collaboration agreement, which has been duly approved by the Government of India, a copy of such agreement is placed at pages 259 to 261 of the Paper Book. In terms of the said agreement, royalty payments are authorized on domestic sales and on export sales @ 5% and 8% respectively of Net sales , subject to taxes. The items of manufacture covered by the foreign collaboration are polymerization initiators , which is a product manufactured by the assessee for use as catalyst in manufacturing of polymers. The approval prescribes that the royalty payable shall be calculated in accordance with the provisions of the Foreign Exchange Control Manual of RBI and other subsisting instructions of Govt. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t to taxes , as per the approval of Govt. of India. 12. Before we proceed further on this aspect, it would be appropriate to refer to a pertinent point asserted by the appellant, which is to the effect that the amount of royalty remitted to the foreign collaboration, i.e. the AE, is as per the provisions of Foreign Exchange Control Manual of RBI. Notably, the approval by the Department of Indus1tr2ial Policy Promotion (Secretariat for Industrial Assistance) dated 11.02.2005 itself prescribes that royalty shall be payable in accordance with the provisions of Foreign Exchange Control Manual of RBI and other subsisting instructions of the Govt. of India/Reserve Bank of India. There is no material on record to suggest that the calculation of royalty made by the assessee has been found to be violative of the respective provisions of FEMA or other subsisting instructions of the Govt. of India/Reserve Bank of India. In this background, a moot question which arises is whether the TPO is competent to rework the royalty payment on the basis of his interpretation of the meaning of expression Net Sales , for the purpose of determining its arm s length price under the CUP method. 1 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... price of the transaction should be taken as NIL . The Hon ble High Court disapproved the action of the TPO, and after referring to the OECD s transfer pricing guidelines observed that the TPO was expected to examine the international transactions as he actually found them. In our considered opinion, the aforesaid parity of reasoning laid down by the Hon ble Delhi High comes into play in the present fact-situation also, as our following discussion would show. 15. In the case before the Hon ble Delhi High Court, the TPO had applied the CUP method while examining the payment of brand fee/royalty, which also is the position in the case before us. The Hon ble High Court referred to the OECD s transfer pricing guidelines for multinational enterprises and tax administrations, and reproduced paras 1.36 to 1.41 of such guidelines, which provide for recognition of the actual transactions undertaken . Thereafter, the Hon ble High Court opined as under :- 17. The significance of the aforesaid guidelines lies in the fact that they recognise that barring exceptional cases, the tax administration should not disregard the actual transaction or substitute other transactions for them 14 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... transaction or to disregard actual transactions. Considered in the context of the OECD guidelines which have been exhaustively referred by the Hon ble Delhi High Court in the case of EKL Appliances Ltd. (supra) the impugned situation does not fit into the two exceptions. Firstly, neither the Reve1n5ue has alleged and nor is there any material on record to suggest that the economic substance of the impugned transaction differs from its form. Secondly, there is no material on record to suggest that there is an arrangement between assessee and the AE made in relation to the impugned transaction which would differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner. We say so for the reason that the entire gamut of royalty payment by the assessee to the AE is in terms of the Foreign Technology Collaboration agreement, which is duly approved by Govt. of India in terms of its Policy, which is applicable across the spectrum. Moreover, it is not the case of the TPO or even of the Revenue before us that the royalty remitted by the assessee to the AE has been found to be inconsistent or violative of the respective Government or RBI ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Only thermal decomposition is possible. Decomposition : The product can decompose at certain temperature. Such decomposition can produce products like Carbon Dioxide (CO2), Carbon Monoxide and 2- ethylhexanol. However none of the original raw materials like Hydrogen Peroxide or Chloroformates can be retrieved. 18. Further, the difference between the key raw material and the finished goods have also been brought out as follows :- Criteria Chloroformate Finished Good storage conditions miscible/reactivity in water purity application appearance Hazard class ambient immiscible with water and reacts 98% to manufacture organic chemicals clear liquid Toxic (6.1) -15 Deg C max miscible with water 50 to 60% initiator to PVC polymerization white emulsion Oxidising agent (5.2) 19. On the basis of the above, it was sought to be canvassed that the chemicals sought to be classified by the TPO as constituent material are indeed raw materials. It is canvassed that the raw materials used by the assessee in its production process including the so-called ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... : Dear Sir, One of our Corporate client wants to remit royalty (No Technical Knowhow paid and royalty rate is 5%, hence covered under Automatic route) to its parent company abroad. For calculation of royalty, among other deductions, landed cost of imported components, standard bought out components used in the manufacture of the final product have to be reduced from the sale price, on which royalty is payable. The query is: Our client is a manufacturing company, in which it is using imported raw materials, which are mixed and used to manufacture the final product. Should this raw materials also be treated at par with the imported components/ bought-out components? and be deducted from sale price to calculate royalty. Would highly appreciate your guidance on the same. Reply : Dear sir, In our opinion, No. Regards BB Sharma. Query : Thanks for the reply. Just to confirm your view on computation, does it mean that only bought out components on which no further processing is required in the company and are directly fitted into the final products are to be subtracted from the selling price? Your guidance in this regard would be highly appreciated. Reply : De ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... for differences, if any, between the international transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the price in the open market; (iii) the adjusted price arrived at under sub-clause (ii) is taken to be an arm s length price in respect of the property transferred or services provided in the international transaction; 25. The aforesaid three steps would reveal that the action of the TPO in the present case is contrary to the prescription contained in sub-clause (i) of clause (a) of sub-rule (1) of rule 10B of the Rules. Ostensibly, in terms of subclause (i), the price charged or paid in a comparable uncontrolled transaction is to be identified for the purpose of determining the arm s length price of the international transaction being tested. It is starkly evident that in the present case, the comparable transaction picked-up by the TPO, namely, royalty payment by TANPC to the AE is a transaction between two related/associated enterprises and therefore it is a controlled transaction and not a uncontrolled transaction . Such a transaction unde2r0taken between two controlled ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... in India and that charged to the AE; and, by multiplying such difference to the quantity exported to AE, an adjustment of ₹ 11,34,000/- has been worked out. 29. The objection of the assessee is to the effect that there is no justification to benchmark the aforesaid transaction in isolation by applying the CUP method whereas the assessee has applied the TNM method for determining arm s length price of its activity of export of finished goods; and, it is further pointed out that it is only in relation to the export sale of Trigonox 25C75 that the price charged from the AE has been found to be on a lower side than the price charged from a third party in domestic sale, whereas in respect of other products sold/exported to AEs the prices charged are higher than those charged from the domestic buyers. In this regard, a reference has been made to a comparative chart placed at page 253 of the Paper Book. Apart from the aforesaid, assessee pointed out before the TPO that Trigonox 25C75, which was exported to the AE at a price of ₹ 239/- per kg. was resold by the AE to the ultimate customer for an amount equivalent to ₹ 288/- per kg.; and, on this basis it is asserted th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... , whereas the prices differed. The price charged from the third party in India was uniform at ₹ 365 per kg. for all the transactions, whereas assessee charged ₹ 239/- per kg. from its AE. Accordingly, the difference between th2e3 price charged from the domestic party and the price charged from the AE was multiplied by the quantity sold to the AE and the resultant difference of ₹ 11,34,000/- has been added to the stated value of the international transaction in order to arrive at its arm s length price. The aforesaid stand of the TPO has been affirmed by the DRP also and in the course of hearing before us, the learned CIT(DR) has sought to defend the same by adverting to the reasoning contained in the order of the TPO, which we have already been noted in the earlier paragraphs and is not being repeated for the sake of brevity. 31. Factually speaking, in the present case assessee has exported finished goods to its AEs and one such export was of a product Trigonox 25C75. In September, 2005 assessee exported 9000 kg. of Trigonox 25C75 at a price rate of ₹ 239/- per kg. to the AE, whereas the same product was also sold by the assessee on three occasions i ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... is claimed to have been made to a customer, who has utilized it for its own consumption. Fourthly, assessee has pointed out that the sales to third parties require certain level of additional costs, viz. selling, marketing, payment follow-up etc., which is not so in case of export to the AE. Fifthly, it is pointed out that the export made to the AE has resulted in an indirect economic benefit by way of obtaining advance license for duty free imports. A rough calculation in this regard has been furnished at the time of hearing in terms of which it is pointed out that such economic benefit was to the tune of ₹ 10-11 per kg.. The aforesaid points brought out by the assessee, in our view, are bonafide grounds to permit adjustment to the comparable uncontrolled price being considered in order to benchmark the transaction of export. Notably, such adjustment is called for, having regard to the provisions of sub-clause (ii) of clause (a) of sub-rule (1) of rule 10B of the Rules and keeping in mind the aforesaid differences. A pertinent point has also been made out by the assessee that after export to the AE,2 5the same product has been ultimately sold by the AE to a uncontrolled ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s segment, assessee had undertaken an international transaction relating to receipt on intending commission and marketing support fee amounting to ₹ 81,66,970/-. For the purposes of benchmarking of the international transaction, assessee used the TNM method and the Operating Profit divided by Total Cost (OP/TC) has been selected as the Profit Level Indicator (PLI) and for the purposes of comparability a set of 5 comparable concerns was selected. The PLI of the five comparables was considered based on the financial data for the last three years and the mean PLI was determined 3.15% and the same being 10% in the case of the assessee, it was the case of the assessee before the TPO that the international transaction relating to receipt of intending commission and marketing support fees was at an arm s length price. However, during the course of the proceedings before the TPO, assessee was required to give the functional details of the comparables as well as PLI based on the single year financial data pertaining to the financial year under consideration i.e. 2005-06. On that basis, it was found that for the two of the comparables, the data for the year under consideration was not ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the field of marketing of machines, tools and spares and it was also incurring losses and thus according to him it was functionally incomparable. It was also loss-making concern, whereas assessee was a cost-protected concern, who was being paid by the AE on the basis of cost plus markup. As a result, the only comparable which remained was Priya International Ltd. (intending segment) with the PLI of 22.58%, and the same was considered for the purposes of benchmarking the international transaction. Accordingly, the PLI of the comparable being 22.58% and that being 10% of the assessee, an adjustment corresponding to the difference i.e. 12.58% was made to the stated values of the international transaction in order to arrive at its arm s length price. Thus resulted in an adjustment of ₹ 11,75,224/- to the returned income of the assessee. 35. Before us, the short point raise2d8 by the assessee is with regard to the exclusion of two comparables, namely, IDC (India) Ltd. and Alfred. According to the appellant Alfred is a concern which was engaged in similar functions of sales and marketing, albeit of machines, tools and spares. According to the assessee, the product differentiat ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... able marketing activity of the assessee is in the field of sale of chemicals manufactured by its AE. On this aspect, we are inclined to agree to the plea of the assessee that merely because of difference in the products dealt with, the two concerns cannot be considered as functionally incomparable so long as they are engaged in performing same functions, especially when the benchmarking analysis is being carried out under the TNM method. Nevertheless, the other objection taken by the TPO in order to reject the said concern for the purposes of the comparability analysis, in our view, is quite justified. The said concern is reported to have incurred a loss and its PLI is said to be -29.52%. At the time of hearing, it was also noticed that in the immediate preceding assessment year the said concern reported a very high profit margin and in the assessment year prior thereof it report a loss. Ostensibly, the financial data reflects inconsistent results, and in the absence of any credible explanation for the inconsistencies, it has been rightly excluded from the list of comparables. 40. Now, we may consider the exclusion of the concern M/s IDC (India) Ltd. from the list of compa ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... penalty proceedings u/s 271(1)(c) of the Act, which, in our view is quite premature and is accordingly dismissed. 42. In the result, appeal of the assessee in ITA No.1477/PN/2010 for assessment year 2006-07 is partly allowed. 43. So far as the appeal for assessment year 2007-08 is concerned, it was a common point between the parties that the issues raised therein, substantively stand on the same footing as has been considered by us in the appeal for assessment year 2006-07, except in relation to the Marketing and Sales support Segment wherein assessee contests the inclusion of one comparable, namely, ICRA Online Ltd. (information services segment). As per the assessee, the said concern is excludible from the list of comparables for the same reasons, which have been applied by the TPO for assessment year 2006-07 while excluding, M/s Gauri Nagvi Ltd. and M/s Agrima Consultants International Ltd.. In this connection, we find that the said concern has been considered as comparable in relation to its Information Services Segment alone. The said segment of ICRA Online Ltd. is engaged in the business of research and support in capital markets (primarily assisting the mutual fund ..... 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