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2016 (6) TMI 635 - ITAT DELHI

2016 (6) TMI 635 - ITAT DELHI - TMI - Inclusion of Royalty as income for the purposes of determination of operating profit - whether it did not form part of the income of the assessee and similarly payment thereof is also requires to be excluded as it is not the operating expense of the assessee - Held that:- As per the Master License agreement and franchises agreement, the assessee has to pass on the entire royalty which it has to receive from franchises and there is no income left to the asses .....

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I of the assessee

Allowing appropriate adjustment of risk assumed vis-a viz-comparable company identified by ld TPO - Held that:- We find considerable force in the argument of the assesse with respect to risk adjustment on account of foreign exchange fluctuation as it is apparent from the account that there is no foreign exchange loss incurred by the assesse therefore we set aside this ground to the file of AO for once again perusing the risk adjustment claimed by the assesse and adju .....

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AO ] in order passed u/s 143(3) of the act dated 27/03/2006 pursuant to the order dated 08/02/2006 of Transfer Pricing officer ( In short TPO ) u/s 92CA(3) of THE Income tax Act 1961 ( hereinafter referred in short The Act ). 2. The grounds of appeal raised by the assessee are as under:- 1. That on the facts and in law the orders passed by the Learned Assessing Officer ("AO")/ Leaned Transfer Pricing Officer ("TPO")/ Learned Commissioner of Income-tax (Appeals) ("CIT(A) .....

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process of law as prescribed under the Act; and that the said report had been mechanically followed by the AO without taking into consideration to the several objections made by the Appellant thereto. 4. That on the facts and in the circumstances of the case, CIT(A) has erred in upholding the action of the AO in making an addition of ₹ 44,89,948 to the returned income of the appellant on account of alleged arm's length price. 5. That on the facts and in the circumstances of the case, C .....

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be excluded. 6. The CIT(A) has erred on the facts and circumstances of the case and in law, by concurring with finding of the AO and by not accepting the economic analysis undertaken by the appellant which was in accordance with the provisions of the Act read with the Income-tax Rules, 1962 ("Rules") for establishing the arm's length price of the international transactions related to royalty and franchisee fees payable to its associated enterprise. Moreover, the AO has not provided .....

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ns related to rendering market support services, payment of royalty and franchisee fee to MDC are closely linked 7. That the TPO/AO/CIT(A) have failed to make appropriate adjustments to account for differences in functions performed, and risks assumed and assets employed by the Appellant, vis-a-vis comparable companies identified by him. 8. That without prejudice to the generality of the grounds of appeal No.1 to 7, on the facts and in law, CIT(A) failed to adjudicate on the applicability of pro .....

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the assessee and similarly payment thereof is also requires to be excluded as it is not the operating expense of the assessee. 5. Brief fact of the case is that McDonald India Pvt.( hereinafter referred to in short MIPL , Assessee , Appellant) ltd has entered into master license agreement with McDonald corporation, US( hereinafter referred to in short MDC) . Under this agreement a license has been granted to assesse with respect to McDonald system including marketing and operational rights on n .....

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Assessee has created two JVs With two other parties who in turn are the sub licensee and they are supposed to pay royalty at 5% and spend another 5% on advertisement. The assesse is further obliged to pay 45000 us $ for each of the new restaurant taken on franchise and which obligation has also been passed on to JVs. This franchise fee was reduced to 22500 US $ from $ 45000/- w.e.f 1stJuly 2002. 6. On these brief facts assesse filed return of income on 22-112003 showing total income of ₹ .....

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ome of the assesse. The assesse replied vide its letter dated 7/02/2006 and 06/02/2006 giving the explanation which was rejected by the AO and made an addition ₹ 9781425/- to the total income of the assesse on this count. 7. The case was also referred to the TPO for determination of Arm s Length Price of its transaction with its Associated Enterprises. The ld TPO adjusted the ALP by an amount of ₹ 4489948/- on account of following international transactions Transaction Amount(INR) Me .....

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d on aggregation basis and included royalty income received from the JVS and paid to McDonald Corporation in operating income and operating expenses respectively while working out PLI of the assesse. Further he excluded the franchise fee received during the year from the operating income as it was not remitted to McDonald corporation in absence of necessary RBI approvals as it was not recognized as expenses in the books of the assesse. Therefore he determined margin 2.68% against the comparable .....

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fore TPO assessee submitted a letter dated 10.01.2006 submitting that Royalty is a pass through cost, it has no margins in that, it has not assumed any onerous responsibility in collection or payment of royalty and by conduct of the party it is risk free and non value addition transactions. However ld TPO rejected the contention of the assessee and hold that as the restaurants are not directly responsible for paying the amount to Macdonald Corporation USA it is not a pass through cost. Ld TPO fu .....

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regation of transaction has rightly been made by TPO and further as the MacDonald corporation has right to make good the default of payment of royalty by franchise by assesse and therefore franchise fee as claimed cannot be a pass through cost. Assesse being aggrieved by the order of ld. CIT(A) on confirmation of ALP determined by TPO has filed this appeal before us. 11. For this the ld AR of the appellant submitted that a. Ld. TPO and CIT (A) has not appreciated the basic fact that Royalty is p .....

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gins and cost base for applying mark-up. It is submitted that conceptually there is no difference between collection and remittance of initial franchisee fees on one hand and royalty fees on the other hand. Therefore, the TPO was not justified in holding that although initial franchisee fees had to be excluded, royalty fees had to be included. c. Further, this issue is covered by the order of Income Tax Appellate Tribunal, Bench-E dated 30.01.2009 in the appellant s own case for A.Y. 2001-2002 w .....

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ment along with franchises agreement, the assessee is not earning anything on account of royalty and entire royalty is to be passed on to Mc Donald s Corporation USA . d. Assesse is a service provider and is charging 10% margin on all the operating cost and royalty and initial franchisee fees are pass through cost. For this he placed reliance on para 2.93 of the OECD guidelines. e. He further relied on decision of the coordinate bench of in case of Cheil Communications India Pvt. Ltd ITA No.712/ .....

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based remuneration model a markup is to be provided only on value added services and in this case royalty and franchisee fee are not value added services and only are pass through cost. Therefore he submitted that the adjustment to ALP confirmed by ld. CIT (A) while considering the royalty in working of PLI may be deleted. 12. Against this LD DR referred to page 265, 109,103 of PB to support the orders of LD TPO. He therefore submitted that royalty is not a pass through cost. He further referre .....

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een noted. 14. Now coming to the issue of whether the royalty is a pass through cost or not. Brief facts of the case is assesse is collecting the royalty and franchisee services fess from the JVs based on the sub licensing agreement and also remits it back to McDonald corporation based on the master license agreement. The amount of royalty that was to be collected by JVs is 5% of gross sales from operation of McDonald restaurants and same amount is required to be remitted by the assesse within f .....

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efault which has occurred either in previous years or in subsequent years.. Therefore there is no risk assumed by the assesse in collection and onward remittance of Royalty. This argument of the assessee has not been controverted by Ld DR. Further it is contention of the assessee that there is no value addition to the collection of royalty amount and reimbursement of the same to the MDC. During the year there is a collection of royalty fees of ₹ 52637830/-and there is a payment of royalty .....

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see fees only. It is not the case of the revenue that assessee has commercially exploited or anyway enjoying the benefit of royalty and franchise fees. Further assesse also cannot keep the some collected on behalf of McDonald corporation because it is required to remit such funds being 5% on gross sales within five days of the end of each month. This also shows that even the benefit of credit or retaining money is also not available with the assesse on account of royalty and franchisee fees. 15. .....

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circumstances would have either paid for the performed the service. In this case the assesse company was set up with that objective and is earning mark-up over the cost incurred separately. The pass through cost are required to be demonstrated in substance and with actual intent. The para No 2.93 of OECD transfer pricing guidelines is as under:- 2.93 In applying a cost based transactional net margin method, fully loaded costs are often used, including all the direct and indirect costs attributa .....

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ces would agree not to earn a mark-up of part of the costs it incurs. The response should not be based on the classification of costs as internal or external costs, but rather on a comparability (including functional) analysis. See paragraph 7.36. 16. The LD TPO as well as the ld CIT (A) has not shown that an independent service provider in comparable circumstances would not have performed such function of collection of royalty and onward remittance of the same to MDC when it is reimbursed for o .....

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sk based on past practices or any experience. No instances have been pointed out by ld TPO or ld CIT(A) to show that risk of nonpayment by franchisee devolving on the assesse is imminent and a real risk. 17. Assessee has further relied on the decision of The decision relied upon 2011] 11 taxmann.com 205 (Delhi) Deputy Commissioner of Income-tax v. Cheil Communications India (P.) Ltd.* where in it is held after considering OECD guidelines as under :- 40. The rival contentions of both the parties .....

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also found by us that in the regular financial accounts maintained by the comparable companies, the comparables recognize revenue on a net basis. The assessee has also recognized revenues on a net basis in its financial account, which had been duly audited by the auditor. The assessee has computed the margin of operative profit on the total cost on the basis of net revenue by way of mark-up received from the associate concern. The payment made by the assessee to third party vendor/media agencies .....

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es placement of advertisement for its AE in the print/electronic etc. media and for that purpose, the assessee is required to make payment to third parties for rendering of advertisement space on behalf of its customers or AEs. It is, thus, clear that the assessee's business is not sale of advertising slots to its customers or associate concern. For performing the functions for and on behalf of AEs, the assessee is remunerated by its AEs on the basis of a fixed commission/charges based on ex .....

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ssee simply acts as an intermediary between the ultimate customer and the third party vendor in order to facilitate placement of the advertisement. The payment made by the assessee to vendors is recovered from the respective customers or AEs. In the event customer fails to pay any such amount to the advertisement agency the bad debt risk is borne by the third party vendor and not by the advertising agency i.e. the assessee. It is, thus, clear that the assessee has not assumed any risk on account .....

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determine ALP as a mark-up on the cost of services but rather on the cost of agency function itself, or alternatively, depending on the type of comparable data being used the mark-up on the cost of services should be lower than would be appropriate for the performance of the services themselves. In this type of case, it will be appropriate to pass on the cost of rendering advertising space, to the credit recipient without a mark-up and to apply a mark-up only to the costs incurred by the interme .....

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through, marked-up, or excluded entirely from the calculation." 41. In the proposed revision of Chapter I-III of the Transfer Pricing Guidelines issued on 9th Sept., 2009 - 9th Jan., 2010 by OECD, it has been provided in para 2.134 as under : "2.134 In applying a cost-based transactional net margin method, fully loaded costs are often used, including all the direct and indirect costs attributable to the activity or transaction, together with an appropriate allocation in respect of the .....

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e should not be based on the classification of costs as 'internal' or 'external' costs, but rather on a comparability (including functional) analysis, and in particular on a determination of the value added by the tested party in relation to those costs." 42. Further, OECD in ITS 2009 Transfer Pricing Guidelines has laid down as under : "7.36 When an AE is acting only as an agent or intermediary in the provision of services, it is important in applying the cost plus met .....

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ervices themselves. For example, an AE may incur the costs of rendering advertising space on behalf of group members, costs that the group members would have incurred directly had they been independent. In such a case, it may well be appropriate to pass on these costs to the group recipients without a mark-up, and to apply a mark-up only to the costs incurred by the intermediary in performing its agency function." 43. In the light of these guidelines, it would be, therefore, clear that a ma .....

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e, we therefore, uphold the order of the learned CIT(A) on this issue and reject the ground raised by the Revenue. 18. The decision of Hon ble Delhi High Court in [2015] 63 taxmann.com 2 (Delhi) Johnson Matthey India (P.) Ltd. v. Deputy Commissioner of Incometax* has also upheld that the cost which does not have any value addition should not form part of the PLI computation of the assesse as under :- 36. The clauses of the agreement between JMIPL and MUL which have been extracted hereinbefore in .....

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from the ultimate customer without any mark-up has not been able to be countered by the Revenue. In other words the contention of JMIPL that its profit is not at all affected by the cost of raw materials remains uncontested. The submissions of the Revenue as to what are true pass through costs fail to acknowledge the actual arrangement between JMIPL and MUL as reflected in the clauses of the agreement as well as in other documents and letters placed on record. 37. The exclusion of pass through .....

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"an independent party in comparable circumstances would agree not to earn a mark-up on part of the costs it incurs." Para 2.94 of the OECD Guidelines further acknowledges that "comparability issues may arise in practice where limited information is available on the breakdown of the costs of the comparables." This Court has in CIT v. EKL Appliances Ltd. [2012] 345 ITR 241 (Delhi) has noted that the OECD Guidelines have been recognised in our tax jurisprudence. What is however, .....

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strated to be at arm's length. 38. It is further importantly pointed out that the very purpose of transfer pricing is to benchmark transactions between related parties in order to discover the true price if such entities were unrelated. If MUL had bought the PGM directly from 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 t .....

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The fact that JMIPL is paid a fixed manufacturing charge per unit shows that costs associated with the possible fluctuations in the price of the raw material is passed on to the customers and does not affect the profits of JMIPL. The submission of the Revenue that the international transaction between JMUK and JMIPL with regard to sale of precious metals may not be at ALP because JMIPL was a wholly owned subsidiary of JMUK does not appear to be based on any definite information but on suspicion. .....

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e as per this Master License Agreement and franchises agreement. Further, the coordinate bench has also held that as per the Master License Agreement along with franchises agreement, the assessee is not earning anything on account of royalty and entire royalty is to be passed on to Mc Donald s Corporation USA. Coordinate bench has held so as under :- 8. We have heard the rival submissions and have gone through the material available on record and the judgments cited by Ld AR of the assessee. We .....

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ion USA @ 5% of gross turnover. Regarding advertisement, clause (vi) of this Master License Agreement is relevant as per which, licensee has to spend during each calendar year for advertisement or promotion of restaurant business for the general public and amount which is not less than 5% of its gross sales. In view of this, we find that as per Master License Agreement dated 1.1.1996, the assessee has to pay 5% of gross turnover to Me Donald's Corporation USA as Royalty and at the same time, .....

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s and there is no income left to the assessee as per this Master License Agreement and franchises agreement. Thereafter, the assessee has entered into a Marketing Support Agreement with the franchises on 1.10.1997. As per this Marketing Support Agreement, the assessee has to contribute some part of the advertisement expenditure which is required to be borne by the franchises. As per clause (d) of this Marketing Support agreement dated 1.10.1997, it is noted that if the business of the franchises .....

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ave also noted that as per the Master License Agreement along with franchises agreement, the assessee is not earning anything on account of royalty and entire royalty is to be passed on to Me Donald's Corporation USA and hence, the Assessing Officer could have examined the allowability of such advertisement expenditure borne by the assessee which was otherwise to be borne by the franchises. Because the so-called increase in return on investment of the assessee will be in the form of dividend .....

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chises, [n this regard, we are of the considered opinion that section 92 of the income Tax Act, 1961 is not applicable with regard to advertisement expenditure which has been borne by the assessee as a result of this agreement} with Indian franchises and the same has resulted into lesser profit/loss of the assessee and more profit to the franchises and it has no impact on the income of the Me Donald's Corporation USA because whether the advertisement expenditure is borne by the assessee or b .....

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the effect that there is no profit to the assessee or lesser profit to the assessee. Therefore it is apparent that the transaction of royalty is a pass through cost which does not result in to any profit and loss to the assessee. 20. In view of the above facts and circumstances we are of the view that while working out PLI of the assessee transaction of Royalty income of ₹ 52637830/- should not be considered as operating income and royalty reimbursed to the MDC of ₹ 52086668/- shall .....

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sessee does not contest the transfer pricing issues as covered by the ground no 6 of the appeal. and hence ground no 6 of the appeal is dismissed. 22. Ground NO. 7 of the appeal is with respect to allowing appropriate adjustment of risk assumed vis-a viz-comparable company identified by ld TPO. 23. Before us it was contended that the appellant business does not involve any risk whereas the comparable companies identified by TPO carry lot of risk. The ld TPO did not make any adjustment in this re .....

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corporation who losses the franchisee fees and royalty fees. Further it was submitted that there is no such failure has happened for last 15 years since Jv are operating in India. He further submitted that only real risk needs to be considered and hypothetical risk which are not based on reality cannot be assumed. Regarding foreign exchange fluctuation loss it was submitted that the royalty and franchisee fees are required to be remitted within five days from the close of the month and therefor .....

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