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2016 (7) TMI 1055 - DELHI HIGH COURT

2016 (7) TMI 1055 - DELHI HIGH COURT - [2016] 387 ITR 611 - Transfer pricing adjustment - application of berry ratio - Held that:- Berry ratio can be used only in very limited circumstances and the limitations that we have listed above are by no means exhaustive. There is also a view expressed that use of Berry ratio as a PLI results in indicating less than fair ALPs in tax jurisdiction where the Assessees have a lower bargaining power. In the aforesaid context, in our view, the TPO had correctl .....

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is based on the value of the goods, would be a valid reason to reject the use of Berry ratio because Berry ratio can only be applied where the value of the goods are not directly linked to the quantum of profits and the profits are mainly dependent on expenses incurred. The fundamental premise being that the operating expenses adequately represent all functions performed and risks undertaken. For this reason Berry ratio is effectively applied only in cases of stripped down distributors; that is, .....

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y ratio would give unreliable results if the product mix of the comparables is different from the product mix of the Assessee. This would make the task of finding a set of comparables fairly difficult. - Decided in favour of assessee. - ITA 381/2013, ITA 738/2015, ITA 382/2013, ITA 702/2014, - Dated:- 22-7-2016 - S. MURALIDHAR & VIBHU BAKHRU JJ. For the Appellants : Mr. C.S. Aggarwal, Senior Advocate With Mr. Prakash Kumar and Mr. Himanshu Sinha, Advocates. For the Respondents : Mr. Ashok K .....

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the Assessee with respect to certain international transactions with its Associated Enterprises (hereafter 'AEs') which are referred to as indenting transactions . The Tribunal has directed that the Arms Length Price (hereafter ALP ) in respect of such transactions be determined on the basis of the average rate of commission earned by the Assessee in respect of transactions with unrelated parties ('Non-AEs'). The Assessee claims that the said direction is patently erroneous as th .....

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ost appropriate method for determining the ALP and, thereafter, compute the ALP in conformity with the discipline of that method. 3. The controversies involved in these appeals as well as the material facts are similar. The questions of law framed in these appeals are also identical and read as under: (1) Whether the Income tax Appellate Tribunal was right in applying and computing arms length price with associated enterprise on indenting transactions by applying average rate of commission with .....

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above questions, only the facts obtaining in ITA No. 381 relevant to AY 2007-08 (ITA No.381/2013) are referred herein. 5. The Assessee was incorporated in 1997 and has its offices in Delhi, Mumbai and Chennai. The Assessee is a subsidiary of Sumitomo Corporation Japan (hereafter the SCJ ) which is one of the largest general trading companies (Sogo Shosha) of Japan. SCJ is the flagship company of the Sumitomo group which is a large conglomerate of companies. The Assessee has seven operating divi .....

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f expenses (payment) 628,502 7. Reimbursement of Expenses (receipts) 14,036,868 8. The Assessee claimed that the transactions of purchase and sale of goods with its AEs were on principal to principal basis. And, the income from rendering support services was in relation to transactions (referred to as indenting transactions) where the Assessee only rendered assistance by following up with the customers and the sale/purchase of goods was done directly by the AE. The Assessing Officer (hereafter t .....

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ofit to operating costs - Berry Ratio - as the Profit Level Indicator (hereafter 'PLI'). The Assessee computed its gross profit on trading transactions (sales on principal to principal basis) by reducing the cost of sales from the aggregate value of sales made to AE as well as Non-AEs. The gross profit on trading segment so computed was then added to commission earned to compute the total gross profits. This amount was taken as the numerator and was divided by operating expenses to compu .....

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classified into two types - Indent sales and Proper sales . In respect of Indent sales , the Assessee merely indents for the goods which are supplied directly by the supplier to the purchaser; the Assessee only receives commission on the value of the invoice or the quantity of goods supplied. In case of Proper sales , the Assessee purchases the goods and sells the same. The purchases made are against confirmed orders and thus, the transactions of purchase and sale are back to back. The Assessee .....

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O, the TNMM could be applied only by determining the net profit margin in relation to the costs incurred, sales affected or assets employed. He reasoned that since the denominator used by the Assessee for computing the Berry ratio excluded the cost of goods, the PLI so worked out was not in accordance with Rule10B(1)(e) of the Rules. The TPO further proceeded to hold that the Assessee had itself indicated that functions performed and risks undertaken in respect of the international transactions .....

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Assessee had assumed significant risks and the commission/service income model did not account for the fair compensation for the value addition made by the Assessee. 14. The TPO rejected the use of Berry Ratio as the PLI for several reasons. First of all, he held that the Assessee had developed unique intangibles like supply chain intangibles and human assets intangibles, which according to him had resulted in huge commercial and strategic advantage to the AE and had enhanced the profit potenti .....

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ought to be taken as the rate of commission on the FOB price of the goods sourced through the Assessee in respect of indenting transactions with the AEs. He, accordingly, computed the arms length commission income from indenting transaction with AEs at ₹ 85,68,44,783/- (being 4.45% of ₹ 19,25,49,38,946) and accordingly directed enhancement of Assessee's income by an amount of ₹ 55,26,16,748/- after reducing the commission of ₹ 30,42,28,035/- as declared by the Assess .....

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al assessment order, the Assessee preferred an appeal before the Tribunal urging several grounds. The Assessee, inter alia, contended that the functions performed and the risks undertaken in respect of principal to principal transactions with Non-AEs were not similar to the indent based transactions with AEs and that the TPO had erred in proceeding on the basis that the said transactions were comparable. The Assessee claimed that in respect of indent transactions, the credit risks and foreign ex .....

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d erred in disregarding the transfer pricing approach adopted by the Assessee for determining the ALP of its international transactions. It was urged that the Assessee's use of TNMM with Berry Ratio as the PLI had been discarded without any valid justification. 20. The Tribunal referred to the tabular statement wherein the TPO had computed the gross profit margin from trading transactions with AEs at 4.80%; gross profit margin on trading transactions with Non-AEs at 4.45%; and commission ear .....

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transactions. The trading transactions involved certain risks and finances whereas in respect of indenting transactions, the Assessee did not incur any financial obligation or carry any significant risks. The Tribunal found that the indent business of the Assessee was nothing but trade facilitation, both in form as well as in substance. It further noted that there was no material on record to regard the indent transactions as trading transaction. The Tribunal further proceeded to note and accep .....

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tered into separate contracts for each transaction and it was not the Assessee's case that each of such separate transaction with an AE was greater in volume as compared to a similar transaction in the Non-AE segment. The Tribunal then proceeded to direct that the commission computed at the rate of 2.26% (i.e. the rate of commission in respect of transactions with Non-AE s) be taken as the bench mark for determining the ALP for commission earned in the AE segment. 22. The Assessee has impugn .....

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he same and made the ALP adjustment without reference to any particular method. He contended that the Tribunal also fell in error in making an adjustment without reference to any particular method. 24. Mr Aggarwal submitted that even if the TPO or the Tribunal found that Berry ratio was not an acceptable PLI, the said authorities could have substituted the same with an appropriate PLI but could not have rejected the TNMM as that was accepted as the most appropriate method in the preceding years, .....

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was coupled with a claim to make an economic adjustment on account of volume and the difference in products. He further submitted that the products in respect of which commission was earned in the Non-AE segment were different from the special products in the AEs segment. He handed over a tabular statement in support of his contention. This statement indicated the products in respect of which indenting transactions were entered into in the Non-AE and the AE segments. He pointed out that in resp .....

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rice (CUP) Method and had used an internal comparable transaction, which was from the same company and the same industry, for determining the ALP. He submitted that this was the most reliable method for computing the ALP and the Assessee could not be heard to dispute the same. He earnestly contended that the above method was proposed by the Assessee with certain economic adjustments which, the Tribunal found were not justified. He submitted that the Assessee had canvassed an adjustment on accoun .....

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that there were only two product categories, namely, telecom and transport where there were no comparables in the Non-AEs segment. He urged that the commission earned by the Assessee in respect of these two segments was at the rate in excess of 5% which was above the average rate of commission of 2.26% in the Non-AE segment. He argued that if the said two product categories were excluded, the ALP adjustment would increase. He further submitted that in order for the Assessee to make good his clai .....

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the profit margin calculated in respect of such segment would increase substantially from 2.26% and would result in a higher ALP adjustment. Reasoning and Conclusion 29. Before proceeding to address the issues, it would be relevant to refer to Section 92C of the Act. The relevant extracts of which are set out below:- 92C. (1) The arm's length price in relation to an international transaction or specified domestic transaction shall be determined by any of the following methods, being the most .....

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all be applied, for determination of arm's length price, in the manner as may be prescribed : Provided that where more than one price is determined by the most appropriate method, the arm's length price shall be taken to be the arithmetical mean of such prices: Provided further that if the variation between the arm's length price so determined and price at which the international transaction or specified domestic transaction has actually been undertaken does not exceed such percentag .....

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on or after the 1st day of April, 2014, shall be computed in such manner as may be prescribed and accordingly the first and second proviso shall not apply. Explanation.-For the removal of doubts, it is hereby clarified that the provisions of the second proviso shall also be applicable to all assessment or reassessment proceedings pending before an Assessing Officer as on the 1st day of October, 2009. 30. It is apparent from the above that ALP has to be computed by the most appropriate method as .....

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of Section 10C of the Rules that postulates that the following factors shall be taken into account for selecting the most appropriate method:- (2) In selecting the most appropriate method as specified in sub-rule (1), the following factors shall be taken into account, namely:- (a) the nature and class of the international transaction [or the specified domestic transaction]; (b) the class or classes of associated enterprises entering into the transaction and the functions performed by them taking .....

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, between the international transaction [or the specified domestic transaction] and the comparable uncontrolled transaction or between the enterprises entering into such transactions; (f) the nature, extent and reliability of assumptions required to be made in application of a method. 31. The Assessee had, for reasons indicated in its transfer pricing report, adopted TNMM as the most appropriate method with Berry ratio as the PLI. Although, the TPO found fault in the use of Berry ratio - accordi .....

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re inclined to accept Mr Aggarwal's contention that although the TPO had discarded the method adopted by the Assessee, it had not followed any particular method in making the ALP adjustment. It appears that the TPO has adopted a hybrid method. He imputed the character of trading transactions to the indenting transactions entered into by the Assessee with its AEs. Having done so, he compared the profit margin realized by the AE from such transactions with profit margin realized by the AE from .....

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uired to raise any invoice for sale and purchase and its financial commitment and risk were inconsiderable. 34. However, we find that the Tribunal erred in proceeding to determine the ALP on the basis of the rate of commission reported by the Assessee in respect of indenting transactions with Non-AEs, without further examination as to the similarity between the two transactions. The Tribunal effectively used the CUP Method for imputing the ALP of Assessee's indenting transaction with AEs. Th .....

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nificant as compared to the transactions in the AE segment against such transactions were only in a few product categories. If the average rate of commission on such transactions was to be applied to the FOB value of the goods involved in the indenting transactions with AEs, the Tribunal would have to satisfy itself that there is no significant variation in the rate of commission between different products. This would confirm that the dissimilarity between the product categories did not have a v .....

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ore us that the TPO had rejected the PLI of Berry ratio but had not rejected the TNMM as the most appropriate method and, therefore, it was incumbent upon him to replace the PLI with whichever ratio he considered appropriate as had been done in the preceding years. He contended that on principles of consistency, he was required to follow the TNMM method. There is much merit in the contention that a method once considered appropriate should be consistently applied unless for good reasons, the TPO .....

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ndertaken for each assessment year. 36. The special provisions for assessing income from international transactions having regard to ALP is of a recent vintage and was introduced by the Finance Act, 2001. The provisions under Chapter X of the Act have undergone significant changes over a period of time. The principles for computation of ALP are also evolving and as such, we are not persuaded to accept that the TPO was required to simply follow the transfer pricing methodology adopted in the prec .....

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d, therefore, the same should also be accepted in the case of the Assessee. The term Sogo Shosha is used in respect of large general trading companies that include within their fold a large network of subsidiary and affiliated companies, thus, enabling the said companies to leverage their network for their business. It is reported that these companies account for a substantial portion of the Japan's overall trade across the world. However, it is not necessary that the trading arrangement bet .....

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he TPO had rejected the same for three reasons. First of all, he held that the same is not permissible under Rule 10B(1)(e) of the Rules; secondly, he held that the Assessee had acquired substantial intangibles in the form of supply chain intangibles and human resources intangibles and Berry ratio was not an apposite PLI in cases where an Assessee used substantial intangibles for its business. Thirdly, the TPO held that the rate of commission on indenting transaction was determined in reference .....

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in method, by which,- (i) the net profit margin realised by the enterprise from an international transaction or a specified domestic transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base; 40. It is clear from the plain language of the above quoted clauses that the net profit margin realised could be computed having regard to any other rel .....

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ours & Co. v. United States: 608 F.2d 445 (1979) to sustain their stand that substantial part of the profits of a subsidiary in Switzerland were rightly allocated to Du Pont. Charles H. Berry, an economist (since deceased) provided necessary evidence in support of IRS's stand by using the ratio of Operating Profits to Selling, General and Administration Expenses to show that more than fair share of profits had been transferred to Du Pont's Swiss subsidiary. This ratio came to be know .....

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to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. 42. The Treasury Regulations as in force during the relevant period contemplated determination of ALP for sale by one controlled entity to another .....

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o show that six of the companies identified by Du Pont as similar to DISA had reported average selling cost which were much higher than DISA. The Court agreed with the evidence produced by IRS's expert that what a business spends to provide services would be a reasonable indication of the magnitude of those services. 43. Berry ratio was used in the above context to show that the average ratio in the case of 21 distributors was 129.3% and in the case of DISA, it was 281.5% for the year 1959 a .....

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allocate such profits of DISA to Du Pont. The Du Pont's challenge to the said ratio as being inappropriate measure was rejected by the Court in the following words:- Whatever the general limits of any particular gauge of industry profitability, plaintiff cannot escape the basic thrust of defendant's proof. Defendant has shown that DISA made extraordinarily high profits which the Commissioner reallocated to an economically reasonable level. 44. Subsequently, in 1990, Berry ratio was inclu .....

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ury Legislation of USA also included depreciation as a part of the Operating Expenses used as a denominator in the berry ratio. As is apparent, Berry ratio has limited applicability; it can be used effectively only in cases where the value of goods have no role to play in the profits earned by an Assessee and the profits earned are directly linked with the operating expenditure incurred by the Assessee. In other words, the operating expenditure incurred by the Assessee effectively captures all f .....

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e substantial fixed assets since the value added by such assets would not be captured in Berry ratio. 46. It can be seen from the above that the Berry ratio can be used only in very limited circumstances and the limitations that we have listed above are by no means exhaustive. There is also a view expressed that use of Berry ratio as a PLI results in indicating less than fair ALPs in tax jurisdiction where the Assessees have a lower bargaining power. In the aforesaid context, in our view, the TP .....

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