TMI Blog2018 (9) TMI 1007X X X X Extracts X X X X X X X X Extracts X X X X ..... by the Transfer Pricing Officer are in different geographical location we do not understand how they can be compared to the assessee. Transfer Pricing Officer having not determined the arm's length price in conformity with statutory provision and in the process having failed to demonstrate that arm's length price shown by the assessee is incorrect, the contention of the learned Departmental Representative to restore the issue to Transfer Pricing Officer for fresh determination of arm's length price is unacceptable - adjustment made to the arm's length price of royalty payment is unsustainable.- Decided in favour of assessee Addition on account of adjustment made to the arm's length price of payment to the AE towards availing Information Systems (IS) services - Held that:- The material submitted before us, which also forms part of the Transfer Pricing Officer’s record, indicates that the cost of the software has been allocated to 40 group companies across the globe who are using the software and related services and assessee’s share in cost allocation works out to 2.3%. Moreover, when the Transfer Pricing Officer himself agrees that the AE has provided software and certain se ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the terms of the agreement, the assessee was required to pay royalty @ 5% on local sales and 8% on value of export sales net of Indian taxes. The technical knowhow is in the nature of licensor secret formula, trade secret, manufacturing procedures, methods and other technical information relating to the manufacturing, compounding, quality control, testing and servicing of the licensed products. For the impugned assessment year, the assessee had filed its return of income on 30th November 2012, declaring loss of ₹ 6,12,59,849. During the assessment proceedings, the Assessing Officer noticing that the assessee has entered into international transaction with its A.E. made a reference to the Transfer Pricing Officer to determine the arm's length price of the international transactions. During the proceedings before him, the Transfer Pricing Officer found that in the transfer pricing study the assessee has benchmarked the arm's length price of the payment made towards technical knowhow by applying Transactional Net Margin Method (TNMM) as the most appropriate method. As alleged by the Transfer Pricing Officer, the assessee failed to furnish the details called for by him an ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... , which is directly used for manufacturing, marketing and sale; Knowhow for which royalty is paid is indivisible part of the business operation; The assessee does not have the formula of the products dealt in, hence, it has to use someone else s formula by paying royalty; and Royalty payment is an acquisition cost of knowhow, without knowhow the production in which the assessee is dealing is not possible. 6. Justifying the change in the method of royalty payment from net sales to gross sales, the assessee submitted that the licensor always intended to collect royalty on gross sales. However, it was not able to do so prior to 2009 owing to the restrictions in the Foreign Direct Investment policy (FDI) prevalent at that time which required net sales to be calculated as per the prescribed formula. As regards the three external CUP proposed by the Transfer Pricing Officer, it was submitted that none of the cases could be considered as external CUP because in the case of the agreement between Strategic Diagnostic Inc. and Romer Labs Technology Inc. is a asset purchase agreement and both the parties are outside India, hence, not governed by Indian rules and regulations. As ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ances of the case is not justified, hence, has to be disallowed under section 37(1) of the Act. Further, he observed, considering that the assessee might be getting some technical inputs to run his manufacturing plant, the assessee would be required to pay 10% of the royalty which was paid during the year. Therefore, he determined the arm's length price of the royalty payment for availing technical knowhow at ₹ 2,01,19,124. Without prejudice to the aforesaid observations, the Transfer Pricing Officer held that if at all assessee s claim of royalty payment is to be allowed, it should be calculated on the basis of net value added sales which is equal to net of Indian taxes, of the net ex factory sale price of the licensed product, exclusive of excise duty, minus the cost of standard bought out component and landed cost of imported components irrespective of source of procurement. He observed that the assessee was paying royalty on the basis of such formula as per the agreement with the A.E. dated 1st January 2005. Therefore, the change in method of royalty payment on gross sales should not be accepted. Thus, ultimately he held that royalty payment should be allowed on the b ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tudy report, the learned Authorised Representative submitted, the AE in Switzerland looks after scientific research for the whole group which enables it to discover over 1,000 new molecules and chemical substances every year, out of which, the most effective are marketed commercially. Looking at the demand of the products thousands of different compositions are created and produced which requires continuous and intensive research. He submitted, all intellectual property rights (IPR) remains with the A.E. in Switzerland. The learned Authorised Representative submitted, while determining the arm's length price the Transfer Pricing Officer has not followed any of the prescribed method as provided in the statute and simply made an ad hoc adjustment on estimated basis which is not legally permissible. In support of such contention, the learned Authorised Representative relied upon the following decisions: i) R.A.K. Ceramics India Pvt. Ltd. v/s DCIT, [2015] 169 TTJ 759 (Hyd.); ii) Reebok India Co. v/s ADIT, [2014] 146 ITD 469 (Del.); iii) CIT v/s Johnson and Johnson Ltd., ITA no.1030/2014, dated 07.03.2017 (Bom.); and iv) DCIT v/s R.A.K. Chemicals India Pvt. Ltd. ITPA no ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ying CUP method should be upheld. The learned Departmental Representative submitted, since, the international transaction between the assessee relates to payment of royalty to the AE, CUP is the most appropriate method. Finally, the learned Departmental Representative submitted, if there is any deficiency in the order of the Transfer Pricing Officer, it can be restored back to him for determining arm's length price denovo by applying a correct method. In support of his contention, the learned Departmental Representative relied upon the following decisions: i) M/s. Gemplus India Pvt. Ltd. v/s ACIT, ITA no.352/Bang./ 2009, dated 21.10.2010; ii) Cranes Software International Ltd. v/s DCIT, [2014] 52 taxmann.com 19 (Bang.); iii) Taegu Tec India Pvt. Ltd. v/s DCIT, [2017] 83 taxmann.com 81 (Bang.); iv) Cairn India Ltd. v/s DCIT, ITA no.1459/Del./2016, dated 09.10.2017; v) M/s. Volvo India Pvt. Ltd. v/s CIT, IT(TP)A no.384/Bang./ 2013, dated 16.12.2016; and vi) M/s. Knorr Bremse India Pvt. Ltd. v/s ACIT, etc., ITA no. 182 of 2013 (O M), dated 06.11.2015; 11. We have carefully considered the rival submissions and perused the material on record. We have also appli ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e of any evidence to suggest transfer of technical knowhow during the year. Having held so, the Transfer Pricing Officer again observed that since the assessee might be getting some technical inputs to run his manufacturing plan, he is required to pay 10% of the royalty paid to the AE during the year. Accordingly, he determined the arm's length price of the royalty payment at ₹ 2,01,19,124 as against the amount of ₹ 18,10,72,120 actually paid by the assessee. Thus, it is evident that the Transfer Pricing Officer has determined the arm's length price of royalty payment by making an ad hoc adjustment purely on estimate basis without following any approved method for determination of arm's length price as prescribed under the statutory provisions. Thus, the primary issue which arises for consideration is, whether the Transfer Pricing Officer has power under the statute to determine the arm's length price of international transaction on estimate basis by weighing in the business expediency factor. In our considered opinion the legal principle on the issue is quite clear. As could be seen from the scheme of the Income Tax Act, 1961, Chapter X contains special ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ity with the statutory provision, hence, unacceptable. The Transfer Pricing Officer is duty bound to determine the arm's length price of the international transaction by adopting one of the method prescribed under the statute and cannot deviate from the restrictions / conditions imposed under the statute. The Hon'ble Jurisdictional High Court in CIT v/s Johnson Johnson Ltd., ITA no.1030/2014, dated 7th March 2017, while dealing with identical issue of determination of arm's length price of royalty by resorting to estimation by the Transfer Pricing Officer has held as under: (d) We find that the impugned order of the Tribunal upholding the order of the CIT(A) in the present facts cannot be found fault with. The TPO is mandated by law to determine the ALP by following one of the methods prescribed in section 92C of the Act read with Rule 10B of the Income Tax Rules. However, the aforesaid exercise of determining the ALP in respect of the royalty payable for technical knowhow has not been carried out as required under the Act. Further, as held by the CIT(A) and upheld by the impugned order of the Tribunal, the TPO has given no reasons justifying the technical know ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... AE. For using such technical know-how, assistance, etc. assessee is required to pay royalty of 3% to its AE both on domestic and export sales. Department has not denied existence of royalty agreement nor the fact that payment of royalty at 3% is as per the terms of the agreement. TPO has also not disputed the fact that there is transfer of technical know-how and assistance from the AE to assessee. What the TPO disputes is the quantum of royalty paid. As can be seen from the TP report of the assessee as well as other materials on record, assessee has benchmarked ALP of royalty paid to AE by applying TNMM. As average margin of comparables selected was 4.32% as against assessee's margin of 11.69%, payment of royalty was found to be within arm's length. Assessee also undertook alternative analysis under CUP method. Assessee has searched Royalstat database which yielded three companies as comparables with average royalty paid of 3.65% on net sales as against 3% by assessee. Therefore, even under CUP method also payment of royalty at 3% was found to be within arm's length. The TPO did not accept assessee's TP analysis under TNMM by observing that payment of royalty being ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tation of ALP under different methods have been laid down in rule 10B. Even, assuming that TPO has followed CUP method for determining ALP of royalty payment, as held by ld. DRP, it needs to be examined if it is strictly in compliance with statutory provisions. Rule 10B(1)(a) lays down the procedure for determining ALP under CUP method. As per the said provision, TPO at first has to find out the price charged or paid for property transferred or services provided in a comparable uncontrolled transaction, or a number of such transactions. Thereafter, making necessary adjustments to such price, on account of differences between the international transaction and comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the price in the open market, TPO will determine the ALP. It is patent and obvious from TPO's order, the determination of ALP at 2% is not at all in conformity with Rule 10B(1)(a). The TPO has not brought even a single comparable to justify arm's length percentage of royalty at 2% either under CUP or TNMM method. On the contrary, observations made by TPO gives ample scope to conclude that adopti ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of royalty payment was untenable and even going by the said basis wrongly adopted by the TPO, no TP adjustment in respect of royalty payment was liable to be made. As per the said basis, the net sales of the assessee after excluding export sale and other income were to the extent of ₹ 1118.70 crores and the royalty paid thereon at ₹ 24.38 crore being less than the rate of 3.5% approved by SIA, there was no case of any excess payment made of royalty by assessee than approved by SIA to justify its disallowance by way of TP adjustment. In our opinion, the ld. CIT (A) could not appreciate these infirmities in the order of the TPO despite the same were specifically brought to his notice on behalf of the assessee and confirmed the TP adjustment made by the TPO in respect of royalty payment which was totally unjustified. We therefore, delete the addition made by the AO/TPO and confirmed by the ld. CIT on account of TP adjustment in respect of royalty payment and allow ground no. 3 of the assessee's appeal. 11. Similar view has also been expressed in the other decisions relied upon by ld. AR. At the cost of repetition, it needs reiteration, assessee has benchmarked ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... such exercise was undertaken by the TPO determined that the reason for the same was increased marketing along with offer of discounts and that there was no justification for payment of royalty at 3% to the AE by the assessee. This reasoning is without legal basis of law as it is not for the TPO to decide the best business strategy for the assessee. In WALCHAND AND CO. PRIVATE LTD. the Supreme Court observed in the context of the Income tax Act, 1922 that when a claim is made for an allowance by the assessee, the income tax authorities have to decide whether the expenditure claimed as an allowance was incurred voluntarily and on grounds of commercial expediency. The Supreme Court pointed out that in applying the test of commercial expediency for determining whether the expenditure was wholly and exclusively for the purpose of business, it has to be adjudged from the point of view of the businessmen and not of the revenue. The Supreme Court concluded that it is open to the revenue to come to the conclusion that the alleged payment was not real or that it had not been incurred by the assessee in the character of a tender or that it was not laid out exclusively for the purpose o ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... vailing technical knowhow from the very inception of its manufacturing activity. Therefore, only because the manufacturing activity is being carried on from past several years, it does not mean that the assessee would not require the technical knowhow of the AE, hence, there is no necessity for paying royalty to the AE. More so, when the Department accepts availing of technical knowhow while allowing a part of royalty even on estimate basis. Therefore, keeping in view the relevant statutory provisions and the principles laid down in the judicial precedents discussed herein above, we hold that determination of arm's length price @ 10% of the amount paid by the assessee on mere assumption and presumption and without any reasonable basis cannot be upheld. Unfortunately, the DRP has not examined the issue in proper perspective keeping in view the relevant statutory provisions. Having held so, it is necessary to deal with the Transfer Pricing Officer s alternative bench marking under CUP method. Though, DRP has not dealt with this issue, however, we deem it appropriate to render our finding with regard to the alternative benchmarking suggested by the Transfer Pricing Officer. As cou ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... IS) services. 17. Brief facts are, in the course of proceedings before him, the Transfer Pricing Officer noticed that the assessee has paid an amount of ₹ 12,96,43,330, for availing Software Services, out of which, the assessee has capitalized an amount of ₹ 5,34,68,651, and claimed the balance amount of ₹ 7,61,74,677, as revenue expenditure. After calling for necessary details relating to the payment made, use of software and actual services provided by the AE, basis for allocation of cost to the assessee, cost incurred by the A.E. and evidences for third party payment made by the AE the Assessing Officer alleged that the assessee failed to furnish the necessary details. Therefore, the Transfer Pricing Officer called upon the assessee to show cause as to why the arm's length price of IS services should not be taken as nil. In response, it was submitted by the assessee that it has switched over the accounting software, stock maintenance software and software for other services into S3 ERP software developed / acquired by the AE it was submitted that the capital expenditure incurred by the AE towards development of such software was apportioned amongst the g ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the Transfer Pricing Officer estimated an amount of ₹ 1,00,00,000 towards cost of software to be paid annually by the assessee. Thus, he determined the arm's length price of the services rendered by the AE at ₹ 1,62,05,000 as against the payment made by the assessee at ₹ 12,96,43,330. Accordingly, he made an adjustment of ₹ 11,34,38,330. While, framing the assessment order the Assessing Officer added back the same amount to the income of the assessee. 18. Being aggrieved, the assessee filed appeal before the DRP. However, the DRP did not find any merit in the submissions of the assessee and upheld the estimation made by the Transfer Pricing Officer as reasonable. However, the DRP directed the Transfer Pricing Officer to verify assessee s claim that a part of the charges have already been capitalized and to restrict the adjustment to the charges debited to the Profit Loss account as reduced by the service charges allowed by the Transfer Pricing Officer as arm's length price of the transaction. Further, the DRP directed the Transfer Pricing Officer to reduce the capitalized IS charges from the cost of asset eligible for depreciation. 19. The le ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... TNS India Pvt. Ltd. v/s ACIT, [2014] 39 CCH 032 (Hyd.); iii) Dresser Rand India Pvt. Ltd. v/s ACIT, [2011] 141 TTJ (Mum.) 2010; iv) DCIT v/s M/s. UCB India Ltd., ITA no.1218/Mum./2014, dated 27.04.2016; v) AWB India Pvt. Ltd. v/s DCIT, ITA no.6480/Del./2012, dated 13.10.2014; and vi) Merck Ltd. v/s DCIT, [2014] 148 ITD 513 (Mum.); and vii) DCIT v/s M/s. Diebold Software Services Pvt. Ltd., ITA no. 4347/Mum./2012, dated 02.04.2014. 20. The learned Departmental Representative relying upon the observations of the DRP and the Transfer Pricing Officer submitted that the assessee did not file proper documentary evidences before the Transfer Pricing Officer to prove availing of services. He submitted, the only evidence submitted by the assessee was a certificate from KPMG which is qualified. He submitted, the assessee failed to substantiate that allocation of cost is at arm's length with uncontrolled transactions. Thus, he submitted, in the absence of proper documentary evidences, the Transfer Pricing Officer was compelled to determine the arm's length price of the price paid for services availed on estimation basis. The learned Departmental Representative submi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... mation of cost of software at `. 1 crore is without any basis. Thus, it is very much clear that the determination of arm's length price by the Transfer Pricing Officer is not as per any one of the methods prescribed under section 92C of the Act r/w rule 10B. As discussed elsewhere in this order, such determination of arm's length price on ad hoc / estimation basis is not permissible under the scheme of the Act as the Transfer Pricing Officer is duty bound to determine the arm's length price by following any one of the most appropriate method prescribed under the statute. It is relevant to observe, the DRP has approved the determination of the arm's length price by the Transfer Pricing Officer without properly appreciating the implication of the relevant statutory provisions. As regards the observations of the DRP regarding the report of the KPMG, it is necessary to observe that the KPMG report is not an audit report but was furnished by the assessee to support the attribution of cost. Therefore, it cannot be said that it is a qualified report. It is further relevant to observe, the material submitted before us, which also forms part of the Transfer Pricing Officer s ..... X X X X Extracts X X X X X X X X Extracts X X X X
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