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2016 (3) TMI 718 - ITAT CHENNAI

2016 (3) TMI 718 - ITAT CHENNAI - TMI - Transfer pricing adjustment - Berry ratio selected as most appropriate method for determining the ALP - Held that:- Considering the facts of the case we are in total agreement with the view of the Revenue on the issue of accepting Berry ratio as the most appropriate method for determining the ALP in the case of the assessee as the contention of the Revenue that the assessee is indulging in value added service to its AEs along with distribution activities i .....

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riate method cannot be accepted.We also make it clear that since the assessee had incurred abnormal expenses for specific activities conducted by the assessee for the predominant benefit of the assessee’s AEs, the decisions cited by the Ld. A.R. are rejected because in those cases only routine expenses were incurred unlike the case of the assessee. - Decided against assessee

Non providing adjustments on account of differences in working capital - Held that:- DRP agreed with the view t .....

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adjustments that were required to be made on account of negative working capital the Ld. DRP did not give effect to working capital adjustments. Before us also the Ld. A.R was not able to justify its stand on working capital adjustments in the case of the assessee with any tangible materials on record. Therefore, we do not have any other option but to reject the claim of the assessee - Decided against assessee

Adjustments on account of foreign exchange fluctuations - Held that:- sinc .....

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lant : Mr.Percy J. Pardivala For The Respondent : Mr.M.M.Bhusari, CIT, D.R ORDER PER A.MOHAN ALANKAMONY , ACCOUNTANT MEMBER: This appeal is filed by the assessee, aggrieved by the order of the Deputy Commissioner of Income Tax, Corporate Circle 4(2) Chennai dated 28.01.2015 passed U/s.143(3) r.w.s. 144C(13) of the Act pursuant to the order of the T.P.O and the directions issued by the D.R.P. 2. The Assessee has raised several grounds in its appeal, however the cruxes of the issue are concised he .....

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atio as profit level indicator (PLI) while computing the ALP. iv) The Ld. Assessing Officer /TPO/DRP had erred in considering routine normal expenses such as employee cost, general and administration cost, selling and distribution cost, and depreciation as Value Added Expenses (VAE) while computing the PLI. v) The Ld. Assessing Officer/TPO/DRP has failed to appreciate that the losses incurred by the appellant were on account of start-up phase of the company. vi) The Ld. A.O/TPO/DRP failed to app .....

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ustments on account of differences in working capital. ix) The Ld. Assessing Officer/TPO/DRP had erred in not granting adjustments towards foreign exchange fluctuations. 3. The brief facts of the case are vividly brought out by the Ld. DRP in their order which is extracted herein below for reference:- M/s.Kubota Agricultural Machinery India Private Limited ( the assessee / Kubota India) was incorporated in the year December 2008 under the Companies Act, 1956 in Chennai and is jointly held by Kub .....

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n of agricultural machineries and related parts. For the purpose of its buy-sell activities, the assessee buys machinery and spare parts from the AE and undertakes resale of the same in the Indian market to third party customers, therefore acting as a limited risk distributor. b. Market research The assessee provides market research services to Kubota Corporation, Japan for which the assessee received separate compensation. For such activities undertaken the assessee is characterized as a limite .....

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le Uncontrolled Price Method (CUP) NA Reimbursement of expenses NA Actual NA Provision of market research services Market Research Transactional Net Margin Method (TNMM) Net cost plus margin 16.05% 6.36% Accordingly, the assessee concluded that the international transactions entered into with the AE, were at arm s length. However, the TPO has not accepted the method adopted by the taxpayer and adopted TNMM as MAM along with Berry Ratio as PLI for the purchase of finished goods. The TPO determine .....

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Berry ratio as a the MAM:- The assessee has applied RP Method because it is applicable in situations where selling and distribution operations carried out by the reseller/distributor does not add substantial value to the product through use of tangible or intangible property. However, the Ld. TPO rejected the RP Method followed by the assessee because of the following reasons:- i) The assessee company is not only a trader but provider of value added services to its AEs. ii) The cost incurred fo .....

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hout analyzing the value added cost of each comparable, true comparability cannot be made. vi) Since the assessee is incurring huge cost such as expenditure relating to advertisement, warranty, supply chain intangible etc., and if undertaking higher risks, then its margins also should be higher, however in the case of the assessee, the margins are very less in fact the assessee is incurring loss. Therefore, the RP Method cannot be adopted in the case of the assessee. vii) Even while analyzing th .....

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Method because of the following reasons:- i) It is just an alternative of cost plus markup model. This ratio evaluates the suitable markup that the principle has to reimburse to its agent . It is best suited for routine distributors and for service providers and more so for captive entities. ii) The very purpose of determining Berry ratio is to ensure that the distributor should earn a return commensurate to the distribution service performed. The distributors must achieve a particular gross pr .....

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dia Pvt Ltd in 137 TTJ 539, the Delhi Bench of the Tribunal held that Operating profit /Value added expenses is to be applied where the appellant performs agency functions to its AE. iv) In the case of the assessee, the assessee company renders many functions to its AEs other than routine trading activity and therefore, reasonable markup on cost has to be accounted. The assessee company had widely advertised the trade mark and the brand legally owned by the assessee s AEs and had incurred substa .....

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y can only be considered as pass through cost . Such pass through costs are irrelevant for the low risk distributor as in the case of the assessee. Under this situation it is essential to verify whether the gross profit or operating profit achieved by the assessee company is commensurate with the total value added cost incurred by the assessee. Therefore in the case of the assessee the most appropriate method to determine the ALP would be to apply the Berry Ratio. vi) The assessee assumes limite .....

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Method. Under TNM Method different PLI is adopted i.e. OP/OC, OP/OI, OP/Assets, OP/VAE etc. Therefore, the assessee s objection that the Berry Ratio is not a recognized method under the provisions of the Act, is not acceptable. x) The argument of the assessee company was that the assessee holds the title of the goods purchased and therefore Berry Ratio cannot be applied because for applying Berry Ratio the assessee should hold only flash title as held in the case of Dupont. This argument is not .....

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fits. xiii) The assessee company was incorporated only to cater to the needs of the AE to distribute the products manufactured by the AE. Therefore, the aggregate profit has to be shared by both the assessee company and the AEs considering the ALP. xiv) During the relevant assessment year, the assessee company had claimed warranty expenses to the tune of ₹ 28,60,589/- in its P&L A/c which shows that the assessee company had assumed the risk of providing warranty. 5.3 The Ld. A.R. had o .....

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beginning phase of the business; therefore the assessee had to incur huge expenditure which would not be a regular feature. iv) The assessee neither bears any significant risk nor deploys significant assets other than the routine tangible assets for the purpose of carrying out its distribution activities. Thus, the function of the assessee company is very limited to buying and selling of the AE s products. v) The marketing research activities undertaken by the assessee is a separate activity an .....

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duced by an appropriate gross margin on this price (the resale price margin ) representing the amount out of which the reseller would seek to cover its selling and other operating expenses and, in the light of the functions performed (taking into account assets used and risks assumed), make an appropriate profit. What is left after subtracting the gross margin can be regarded, after adjustment for other costs associated with the purchase of the product (e.g. custom duties), as an arm s length pr .....

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he company accepted the fact that it is limited risk distributor which is entitled to the margins based on the case incurred by them which however has not actually been reflected in this case. Hence, we reject the objections of the assessee and uphold the action of the TPO. After further analyzing the issue, the Ld. DRP once again agreed with the view of the Ld. TPO that the Berry Ratio would be the most appropriate method in the case of the assessee to determine the ALP. The relevant portion of .....

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may or may not be included in the operating expenses, depending in particular on the possible uncertain they can create in relation to valuation and comparability. This panel upholds the action of the TPO as he has taken uniform stand while computing the operating/value added expenses in the case of assessee and comparable companies. This panel finds that the contention of the assessee in respect to value added cost i.e, that only advertisement, marketing and promotion expenses are to be conside .....

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decline to accept the contention that abnormal adjustment was made by the TPO as the quantum of adjustment was the result of FAR analysis. Coming to the next point, as to whether Berry Ratio is to be adopted or not, the following important factors have to be considered: - Whether the assessee company is engaged in distribution activity with a limited risk. The main issue in this case is adjudication on the question whether ...(the assessee ).. is being adequately compensated for the functions pe .....

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to the use of this ratio worldwide, and for the reasons we will set out in detail in a short while, the use of this ratio cannot be eliminated from the Indian transfer pricing practices altogether. In the July 2010 version of OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Berry Ratio is specifically recognized as follows: Berry Ratios are defined as ratios of gross profit to operating expenses. Interest and extraneous income are generally excluded from t .....

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used and risks assumed) is proportional to the operating expenses. • The value of the functions performed in the controlled transaction (taking account of assets used and risks assumed) is not materially affected by the value of the products distributed, i.e. it is not proportional to sales, and • The taxpayer does not perform, in the controlled transactions, any other significant function (e.g. manufacturing function) that should be remunerated using another method or financial indica .....

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ading business involving back to back trading without any value addition to the goods traded, which is what AE is engaged in and the assessee is contributing to, satisfies all these tests. We are in agreement with the approach adopted by the OECD document in this regard. Going by this approach, and, applying the tests laid down above, it does indeed seem that Berry Ratio could be appropriate in the present case. Berry Ratio is increasingly finding specific acceptance in many jurisdictions. While .....

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epend on the functions performed and the related risks borne by it, with respect to the goods. What Berry Ratio thus seeks to examine is the relationship of the operating costs with the operating profits. It thus proceeds on the basis that there is a cause and effect relationship between operating costs and the operating profits. In this scenario it is necessary to consider that if an independent distributor would do all such marketing support/Brand promotion! Distribution functions on behalf of .....

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nation of the ALP. Moreover, Berry Ratio cannot be applied as PLI under CPM as per Rule 10B (1)(c) of the Rules which prescribes gross profit to direct and indirect cost of production as PLI under CPM. ii) Resale Price Method is the most appropriate method considering the fact that the assessee buys from the related parties and sale to unrelated parties. iii) No Value Added activities undertaken by the assessee but only routine operations of the cost of the income. iv) The assessee had incurred .....

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ustomers and therefore there was no Value Addition made to the products of the AEs. ix) The market research activities conducted by the assessee were restricted to data collection from the potential customers of the assessee and the same was dealt as separate business segment from which the assessee was remunerated separately. x) The warranty expense was borne by the AEs and not by the assessee. xi) Business promotion expenses incurred by the assessee was routine in nature such as trade fair/exh .....

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ed in support of the same. 5.7 We have heard both the parties and carefully perused the materials available on record. Considering the facts of the case we are in total agreement with the view of the Revenue on the issue of accepting Berry ratio as the most appropriate method for determining the ALP in the case of the assessee because of the following reasons:- i) It is undisputed fact that the assessee has incurred huge expenses on account of advertisement, supply chain intangibles, marketing a .....

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lifting the corporate veil of the assessee company it is apparent that all the parties are closely inter-related and thereby has enormous influence in their respective functioning. iii) In such circumstances, it is obvious that the AEs would be mainly interested to absorb maximum profit leaving over either Nil or minimal profit to the assessee company. iv) Further it is apparent that the assessee company has been aggressively advertising and indulging market promotion activities etc., in order t .....

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hat the assessee is indulging in value added service to its AEs along with distribution activities is unquestionable. vi) The Berry ratio is the ratio of gross profit to operating expenses and is named after American economist Professor Charles Berry, who first applied in the transfer pricing court case E.I du Pont de Nemours & Co. v. U.S.,608 F.2d 445(Ct.Cl.1979). The du Pont case involved a distributor which also performed related marketing services. When evaluating the performance of the .....

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s operating expenses. The Berry ratio has been recognized in the U.S transfer pricing regulations since the early 1990s. Generally, the berry ratio should only be used to test the profits of limited risk distributors or service providers that do not own or use any intangible assets. This is because the reliability of the Berry ratio depends upon the existence of a relationship between gross profits and operating expenses. Chapter 2 of the OECD Guidelines gives the example of intermediary activi .....

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Berry ratio can also be useful when applied to limited risk distribution of high volume/low margin products as in the case of the assessee. vii) Berry ratio is accepted as a permissible tool for determining ALP by the Tribunal in the case Mitisubishi in ITA No.5042/Del./2011. It was held in the case that in a situation were significant functions and risks pertaining to inventories were not undertaken, the cost of inventory become irrelevant and only the value added expenses needed to be conside .....

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as per Rule 10B(1C) of the Rules, is not acceptable. ix) In the case of the assessee company it was not a routine purchase and sale transactions but immense activities were performed in order to bring awareness of the existence of the AE s products and the AE. Therefore, the contention of the Ld. A.R. that Resale Price Method is most appropriate method cannot be accepted. x) The argument of the Ld. A.R. that no value added activities is undertaken by the assessee is not justified because the as .....

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start-up phase. xii) Market research activities performed by the assessee company is inter linked with the distribution activities of the Assessee Company and inseparable. Further, we also find that proper segmental accounting is also not carried out by the assessee. xiii) It is pertinent to mention that the assessee company not only established a dealer network for selling the products of the AEs to the end customers but also made tremendous awareness of the existence of the assessee s AEs and .....

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e Ld. A.R. that the pricing decision was made by the assessee and not by the AEs since both the parties are independent is also not acceptable because the structure of the assessee firm is such that the AEs has a tremendous influence in the functioning of the assessee company as the entire shares of the assessee company are held by the AEs. xvii) Further, to avoid further repetition we hereby affirm that we are in agreement with the reasoning discussed by the Revenue in the respective orders whi .....

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has not provided working capital adjustments which materially affect the profit of the assessee. The Ld. DRP agreed with the view that adjustments has to be granted for eliminating material effects, if any, arising out difference in working capital between the tested party and comparables. It was the contention of the assessee that it was having negative working capital as against substantial positive working capital enjoyed by the comparables. Ld. DRP observed that the assessee has not demonst .....

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aim of the assessee. It is ordered accordingly. 7.1 Ground No.(ix):- Adjustments on account of foreign exchange fluctuations:- The Ld. DRP was of the view that the quantum of derivative losses/gains is independent to the extent of the services rendered and is determined entirely outside the parameters of the service provider s actual business. The Ld. DRP further observed that as far as the adjustment on account of foreign exchange fluctuations, the assessee claimed that the foreign exchange flu .....

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