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Frigoglas India Pvt. Ltd. Versus DCIT, Circle-9 (2) , New Delhi

Allowance of Royalty as business expenditure - transfer pricing adjustment - Held that:- In the present appeal, what we see is the TPO sitting on judgment on the business and commercial expediency of the assessee which is erroneous as per the provisions of the Act as laid down clearly by the Hon'ble Delhi High Court in EKL Appliances (2012 (4) TMI 346 - DELHI HIGH COURT).

Furthermore, we are of the opinion that once TNMM has been applied to the assessee company’s transaction, it cover .....

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deep Nagpal, CA For The Respndent : Shri Amendra Kumar, CIT DR ORDER PER SUDHANSHU SRIVASTAVA, JUDICIAL MEMBER This appeal has been preferred by the assessee against the assessment order dated 27.01.2015 for assessment year 2010-11 passed u/s 143(3) r.w.s. 144C of the Income Tax Act, 1961 (hereinafter called the Act ). 2. The assessee, Frigoglass India Pvt. Ltd. (FIPL), was established in November 1998 and is a subsidiary of Norcool Holding ASA, Norway. The assessee is in the business of glass d .....

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r the following chart - International transactions shown by the taxpayer: Sr. No. Nature of transaction Method Selected Arm's length price as per taxpayer (i) Purchase of raw materials TNMM using Operating profit 10,477,158 (ii) Purchase of trading goods 37,051,810 (iii) Payment of royalty 84,765,448 (iv) Payment of management consultancy fees 48,591,848 (v) Sale of finished goods -as PLI Operating Revenue 27,347,679 (vi) Sale of components and spares 27,312,504 (vii) Receipt of sales commis .....

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tional transactions proposed to make assessment at an income of ₹ 18,16,36,630/- after making the following additions/disallowances - i) Disallowance of difference in Arms Length Price (ALP) ₹ 8,77,31,148 ii) Disallowance of Miscellaneous Expenses ₹ 8,55,912 5. Aggrieved by the action of the Assessing Officer, the assessee approached the Disputes Resolution Panel (DRP) and raised the following objections:- 1. The learned TPO erred on the facts and circumstances of the case and .....

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ng to payment of royalty and management fee to its Associated Enterprise ( AE") on a standalone basis by rejecting TNMM as the most appropriate method ( MAM ).in doing so, the learned TPO erred in not considering the transaction by transaction analysis submitted by the Assessee during the assessment proceedings. 3. The learned TPO erred, on facts and circumstances of the case and in law, in arbitrarily selecting Comparable Uncontrolled Price ( CUP") method as the most appropriate metho .....

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ad-hoc and irrational approach to re-compute the ALP of payment of management fee, without establishing the existence of any comparable uncontrolled transactions and demonstrating their comparability with the Assessee; 4. The learned TPO erred, on facts and circumstances of the case and making an adjustment of INR 2,965,700/- to the total income of the Assessee under section 92CA(3) of the Act on account of adjustment in the arm's length price of the international transaction of payment of m .....

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e to be NIL and making an adjustment of INR 84,765,448 to the total income of the Assessee under section 92CA(3) of the Act on account of adjustment in the arm's length price of the international transaction of payment of royalty. In doing so, the learned TPO have erred in: a) Disregarding the documentary evidence submitted by the Assessee and alleging no services were actually received by the assessee; b) Misinterpreted/ misconstrued the facts with respect to the international transactions .....

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onal transaction by adopting one of the prescribed methods only. 7. The Learned AO has erred on facts and in law in disallowing miscellaneous expenses amounting to INR 855,912 being 5% of the total miscellaneous expenses, on adhoc and arbitrary basis alleging that the expenditure incurred by the Assessee is not totally vouched. In doing so, the Ld. AO has failed to bring on record any evidence to demonstrate how the said expense is unreasonable. 6. The DRP adjudicated these issues as under:- (i) .....

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y, the TPO was justified in determining the ALP separately rather than aggregating it with other transactions under Transactional Net Margin Method (TNMM). The DRP further held that since the assessee could not substantiate the benefit derived from the payment of royalty, the TPO was justified in holding the ALP for payment of royalty to be at NIL. (iii) As regards the issue of selection of CUP as the Most Appropriate Method of TNMM for benchmarking the payments made on account of intra group se .....

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actions of payment of management fee, the DRP held that the assessee had made payments for services availed which contained two mark-ups, one by the entity rendering the services and the other by the entity in Greece. Therefore, the second mark-up of 6.5% was rightly to be adjusted in the determination of ALP. (v) As regards the ad hoc disallowance of 5% of the miscellaneous expenses, the DRP ruled in favour of the assessee and held that since the disallowance was not supported by any evidence, .....

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preferred the following grounds of appeal:- 1. 1.1. The learned Deputy Commissioner of Income Tax, Circle- 9(2), New Delhi ( the Assessing Officer or the Ld. AO ) pursuant to directions of Hon ble Dispute Resolution Panel ( Hon ble DRP ), has erred on facts and circumstances of the case and in law in completing the present assessment at an income of ₹ 18,16,36,630 as against the returned income of ₹ 9,30,49,569 is bad in law. 1.2. That, the Learned Deputy Commissioner of Income Tax, .....

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sis of the Appellant, for determination of the arm's length price ( ALP ) in connection with the impugned International transactions. 2.2. That the Ld. TPO/ Hon ble DRP has grossly erred in rejecting the Combined transaction approach of benchmarking adopted by the Appellant in its transfer pricing analysis by selecting Transitional Net Margin Method ( TNMM ) as the most appropriate method ( MAM ) for determining the arms length price ( ALP ) of payment of royalty and payment of management fe .....

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re of the transaction under analysis; 3. 3.1. That the Ld. TPO/ Hon ble DRP erred in not conducting the analysis of selecting the MAM as prescribed under Rule 10C of the Rules and accordingly not documented the same as prescribed under Rule 10D of the Rules. 3.2. The Ld. TPO/ Hon ble DRP erred in law by upholding the determination of the ALP of the international transaction using Comparable Uncontrolled Price ( CUP ) method without following the manner of applying the CUP method prescribed under .....

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mation and documents provided by the Appellant to substantiate the services and benefits received by the appellant in lieu of payment of royalty, and based on a preoccupied mind reached at an inappropriate conclusion that the arm s length value of the transaction pertaining to payment of royalty should be Nil. 4.2. The Ld. TPO/ Hon ble DRP erred in misinterpreting/ misconstrued the facts with respect to the international transaction relating to payment of and royalty on the basis of incorrect pr .....

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ommercial rationale of the legitimate business expenses incurred by the taxpayer and not restricting the scope of assessment under section 92CA to determining the arm s length price of the international transaction by adopting one of the prescribed methods only. Disregarding the directions of the Hon ble DRP. 6.1. The Learned AO has erred on facts and in law in disallowing miscellaneous expenses amounting to INR 855,912 being 5% of the total miscellaneous expenses, on ad-hoc and arbitrary basis .....

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O to delete the adjustment; 7. 7.1 That on the facts and in the circumstances of the case, the Ld. AO has erred in charging interest under 234A, 234B, 234C and 234D of the Act, as consequences of the additions made in the assessment order passed under section 143(3) read with section 144C of the Act. 7.2 The Appellant denies its liability to such interest and prays that the AO be directed to delete the levy of aforesaid interest as it is entirely a result of additions/disallowance and consequent .....

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e grounds raised by the Appellant, as per law. 9. On the issue of royalty, the Ld. AR submitted that the assessee has entered into royalty agreement with its AE - Frigoglass SAIC (Head Office) on account of receipt of ICM Technology and for use of trademark. It was submitted that CUP method could not be applied in the case as neither the AE nor the assessee have entered into similar royalty arrangements with third parties and the data for external comparable transactions between independent part .....

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d sale of glass door refrigerators. Accordingly, for the purpose of economic analysis, the assessee combined the international transaction pertaining to payment of royalty as in this case; the transaction was so closely linked or continuous that it could not have been evaluated adequately on an individual basis. Therefore, the transactions pertaining to payment of royalty were considered as closely linked to the manufacture of glass door refrigerators and a combined transactions approach was use .....

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ltant for reviewing the arm s length nature of 4% royalty applied by the Head Office for the licensing of the ICM technology and trademarks to related group entities and based on the terms and conditions of the License Agreement between Frigoglass SAIC and its affiliates and in view of the broadly comparable licensing agreements identified from the search of publicly available license agreements, it was concluded that a royalty rate of 4% on sale of products for the use of trademarks and ICM tec .....

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ogy from very inception although a formal agreement was entered into in September 2007 and had started making payment for such services from Assessment Year 2009-10 only. It was further submitted that the activities performed by the AE in terms of the royalty agreement were ICM sales, customer service, marketing services, product development and future technologies. It was submitted that most of the clients of the FIPL were global clients and the use of the trademark had a positive impact on the .....

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as per the terms of the agreement. The Ld. AR submitted that the disallowance for royalty was ultimately made on the ground of commercial expediency and he placed reliance on the decision of the Hon'ble Delhi High Court in the case of CIT vs EKL Appliances Ltd. 345 UTR 241 (Del) and that of the ITAT Hyderabad B Bench in the case of DCIT vs Air Liquide Engineering in I.T.A. No. 1040/Hyd/2011 for the proposition that so long as the expenditure or payment has been demonstrated to have been incu .....

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ed in the determination of costs for services rendered by FIPL. Such cost details were sent to Frigoglass SAIC where similar costs were pooled from different Frigoglass entities globally. Once a combined cost pool was determined, costs were allocated to different entities on the basis of benefits received by the particular entity. The Ld. AR elaborated that FIPL renders certain support services to its AE and these services offered by FIPL are similar in nature to some of the services provided by .....

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the direct and indirect cost incurred to provide these services to other group entities (including FIPL) and once the cost is accurately determined by each group entity, such cost details are sent to Frigoglass SAIC where similar costs are pooled from different Frigoglass entities globally. This combined cost pool is then adjusted for costs incurred on shareholder activities and duplicate services. Once a combined cost pool is determined, costs are allocated to different entities on the basis of .....

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ted that Frigoglass SAIC had hired an independent external consultant for reviewing the Arm s Length Nature of the 6.5% mark-up applied by the Head Office for rendering management support services to related group entities. The search for comparable services providers resulted in the identification of 720 independent companies. These comparables exhibited an arm s length inter-quartile range of 3.7% to 13.3% with a median of 7.4%. On the basis of this, the 6.5% cost plus mark-up charged by the F .....

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t analysis. The Ld. AR refereed to the Allocation Sheet appearing on page 10 of the order of the TPO and submitted that the TPO has mixed up two sets of transactions viz. availing of services from AE at cost plus 6.5% mark-up and rendering services to AE at cost plus 15% mark-up. Referring to Para (ii) on page 9 of the TPO s order, the Ld. AR pointed out that the Agreement with Cyprus referred to in the said Para was an altogether different agreement, a copy of which is placed at page 1470 of Pa .....

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direction on this issue also. 14. In response, the Ld. DR placing reliance on the orders of the DRP as well as the TPO submitted on the issue of royalty that the principle of commercial expediency cannot take away the essence of OECD guidelines and the benefit accruing as a result of the payment of royalty has to be examined. He emphasized that the assessee has failed to demonstrate as to what direct benefit had accrued to the assessee from the payment of royalty. He alleged that in absence of p .....

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Ltd. vs DCIT in I.T.A. No. 1626/Del/2015 wherein the Bench had upheld the action of the DRP in determining the ALP of intra-group services received from its AE at nil. The Ld. DR submitted that the order of the DRP should be upheld. 15. On the issue of management fees, the Ld. DR submitted that the TPO had correctly calculated the disallowance and as such, no restoration was necessary. On the issue of disallowance of miscellaneous expenditure, the Ld. DR, in all fairness, accepted that the TPO .....

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running of its business. In CIT vs EKL Appliances 341 ITR 241 (Del), the Hon'ble Delhi High Court had the occasion to consider an issue of disallowance of royalty by TPO because the assessee in that case had been suffering losses, the Hon'ble High Court while holding that so long as the expenditure or payment by assessee has been demonstrated to have been incurred or laid out for the purposes of business, it is no concern of the TPO to disallow the same on any extraneous reasoning, obse .....

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which would be made between independent enterprises then any profit which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, if not so accrued, may be included in the profits of that enterprise and taxed accordingly. By seeking to adjust the profits in the above manner, the arm s length principle of pricing follows the approach of treating the members of a multi-national enterprise group as operating as separate entities rather than as in .....

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he associated enterprises as it has been structured by them, using the methods applied by the taxpayer insofar as these are consistent with the methods described in Chapters II and III. In other than exceptional cases, the tax administration should not disregard the actual transactions or substitute other transactions for them. Restructuring of legitimate business transactions would be a wholly arbitrary exercise the inequity of which could be compounded by double taxation created where the othe .....

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he parties characterization of the transaction and recharacterise it in accordance with its substance. An example of this circumstance would be an investment in an associated enterprise in the form of interest -bearing debt when, at arm s length, having regard to the economic circumstances of the borrowing company, the investment would not be expected to be structured in this way. In this case it might be appropriate for a tax administration to characterize the investment in accordance with its .....

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price. An example of this circumstance would be a sale under a long-term contract, for a lump sum payment, of unlimited entitlement to the intellectual property rights arising as a result of future research for the term of the contract (as previously indicated in paragraph 1.10). While in this case it may be proper to respect the transaction as a transfer of commercial property, it would nevertheless be appropriate for a tax administration to conform the terms of that transfer in their entirety .....

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m the relationship between the parties rather than be determined by normal commercial conditions as may have been structured by the taxpayer to avoid or minimize tax. In such cases, the totality of its terms would be the result of a condition that would not have been made if the parties had been engaged in arm s length dealings. Article 9 would thus allow an adjustment of conditions to reflect those which the parties would have attained had the transaction been structured in accordance with the .....

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that the guidelines discourage re-structuring of legitimate business transactions. The reason for characterisation of such re-structuring as an arbitrary exercise, as given in the guidelines, is that it has the potential to create double taxation if the other tax administration does not share the same view as to how the transaction should be structured. 18. Two exceptions have been allowed to the aforesaid principle and they are (i) where the economic substance of a transaction differs from its .....

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firmed by the Tribunal. These guidelines, in a different form, have been recognized in the tax jurisprudence of our country earlier. It has been held by our courts that it is not for the revenue authorities to dictate to the assessee as to how he should conduct his business and it is not for them to tell the assessee as to what expenditure the assessee can incur. We may refer to a few of these authorities to elucidate the point. In Eastern Investment Ltd. v. CIT , (1951) 20 ITR 1, it was held by .....

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reme Court that in applying the test of commercial expediency for determining whether the expenditure was wholly and exclusively laid out for the purpose of business, reasonableness of the expenditure has to be judged from the point of view of the businessman and not of the Revenue. It was further observed that the rule that expenditure can only be justified if there is corresponding increase in the profits was erroneous. It has been classically observed by Lord Thankerton in Hughes v. Bank of N .....

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15 ITR 519, and it was observed as under: - We fail to appreciate how expenditure which is otherwise a proper expenditure can cease to be such merely because there is no receipt of income. Whatever is a proper outgoing by way of expenditure must be debited irrespective of whether there is receipt of income or not. That is the plain requirement of proper accounting and the interpretation of Section 57(iii) cannot be different. The deduction of the expenditure cannot, in the circumstances, be held .....

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CIT, (1979) 118 ITR 261 (SC), the Supreme Court referred to the legislative history and noted that when the Income Tax Bill of 1961 was introduced, Section 37(1) required that the expenditure should have been incurred wholly, necessarily and exclusively for the purposes of business in order to merit deduction. Pursuant to public protest, the word necessarily was omitted from the section. 21. The position emerging from the above decisions is that it is not necessary for the assessee to show that .....

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sion in the OECD guidelines, in the paragraphs which we have quoted above. 22. Even Rule 10B (1)(a) does not authorise disallowance of any expenditure on the ground that it was not necessary or prudent for the assessee to have incurred the same or that in the view of the Revenue the expenditure was unremunerative or that in view of the continued losses suffered by the assessee in his business, he could have fared better had he not incurred such expenditure. These are irrelevant considerations fo .....

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ority for that. What the TPO has done in the present case is to hold that the assessee ought not to have entered into the agreement to pay royalty/ brand fee, because it has been suffering losses continuously. So long as the expenditure or payment has been demonstrated to have been incurred or laid out for the purposes of business, it is no concern of the TPO to disallow the same on any extraneous reasoning. As provided in the OECD guidelines, he is expected to examine the international transact .....

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earlier. Full justification supported by facts and figures have been given to demonstrate that the increase in the employees cost, finance charges, administrative expenses, depreciation cost and capacity increase have contributed to the continuous losses. The comparative position over a period of 5 years from 1998 to 2003 with relevant figures have been given before the CIT (Appeals) and they are referred to in a tabular form in his order in paragraph 5.5.1. In fact there are four tabular statem .....

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ovisions of the Act as laid down clearly by the Hon'ble Delhi High Court in EKL Appliances (supra). As far as the Department s reliance on the Hon ble Delhi High Court s judgment in Abhinandan Investments (supra) and on the decision of the co-ordinate I Bench of the Delhi Tribunal in the case of Bombardier Transporation India Pvt. Ltd. is concerned, these judgments were rendered on a different set of facts and hence the ratio as laid down by these are not applicable to the facts of the prese .....

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he TPO has made the disallowance in question mainly on the basis of the benefit test. In this regard, it is seen that the payment of royalty cannot be examined divorced from the production and sales. Royalty is inextricably linked with these activities. In the absence of production and sale of products, there would be no question arising regarding payment of any royalty. Rule 10A (d) defines 'transaction as a number of closely linked transactions. Royalty, then, is a transaction closely link .....

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