TMI Blog2019 (3) TMI 1837X X X X Extracts X X X X X X X X Extracts X X X X ..... this issue to Ld. Transfer Pricing Officer because factual information on the issues raised by the Hon ble Court are not before fully. The Ld. TPO may also decide the issue of direct selling expenses and applying markup following the decision of the Hon ble Delhi High Court in the case of Sony Ericsson (supra). It is needless to mention that assesses shall be afforded adequate opportunity of being heard. - ITA No.7414/Del/2018 And S.A. No.870/Del/2018 [In ITA No.7414/Del/2018] - - - Dated:- 27-3-2019 - SHRI AMIT SHUKLA, JUDICIAL MEMBER AND SHRI O.P. KANT, ACCOUNTANT MEMBER For the Appellant : Sh. Alok Vasanti, Adv. For the Respondent : Sh. H.K. Choudhary, CIT(DR) ORDER PER O.P. KANT, A.M.: This appeal by the assessee is directed against final assessment order dated 24/10/2018 passed by the Ld. Dy. Commissioner of Income Tax, Circle-3, Gurugram [hereinafter referred to as the Assessing Officer ] pursuant to the direction dated 14/09/2018 of the learned Dispute Resolution Panel(DRP) for assessment year 2014-15. In the grounds of appeal raised, the assessee is agitated mainly against adjustment made to advertisement, marketing and promotion (AMP) exp ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... er the provisions of the Act without demonstrating the existence of any understanding or an agreement between the Appellant and its AEs which requires the Appellant to spend excessively towards brand promotion. a. The assumption of existence of an International transaction without having any valid agreement as basis has been overruled by the Hon ble HC in the cases of Maruti Suzuki India Limited and Whirlpool of India Limited. 6. That on the facts and in circumstances of the case and in law, Ld. AO / TPO/ DRP erred in not appreciating that the sales promotion expenses incurred by the Appellant are wholly and exclusively focused on generating domestic sales for its distribution operations and the benefit arising from the incurrence of sales promotion expenses by the Appellant has been received by the Appellant with the benefit, if any, resulting to its AEs is merely Incidental. 7. The Ld. AO / TPO/ DRP has erred in not appreciating that marketing is one of the primary functions undertaken by the Appellant and the beneficiary on account of incurring of AMP expenses was the Appellant itself and the same does not require to be compensated / remunerated separately by the AE fo ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Without prejudice to the above grounds, the AO / TPO / DRP erred in facts and circumstances of the case and in law in using inappropriate comparables for the purpose of applying such markup. 16. Without prejudice to the above grounds, the TPO has erred in facts and circumstances of the case in computation of working capital adjusted margins of the comparables selected pursuant to DRP directions. GROUNDS PERTAINING TO PROTECTIVE ADJUSTMENT 17. That protective adjustment based on Bright Line Test as proposed by Id. AO / TPO/DRP in his order/directions is against the principles laid down by Hon ble Delhi HC. In the absence of any stay on this decision by the Hon ble Supreme Court, the decision of Hon ble High Court holds the field and is fully operational as of now especially with context to Bright Line Test ( BLT ). Hence, in view of binding nature of this judgment to the office of AO/TPO/DRP, the Appellant submits that this approach should not be considered. 18. That under the provisions of Income Tax Act, there is no provision of protective assessment in case of matters overruled by High Court. The order of TPO/AO/DRP is completely unlawful and should be quashed. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... complied with. The Assessing Officer noticed international transaction with its Associated Enterprises (AE s), reported by the assessee and accordingly, he referred the matter for determination of arm s length price of those international transactions to the Ld. Transfer Pricing Officer (TPO). A list of international transactions entered into by the assessee relates to AE are reproduced as under: S. No. Description of the transactions Amount (Rs. 1 Import of finished goods 83,39,07,222 2 Import of consumables 48,04,602 3 Import of assessories for Demo Loaner other items 95,53,192 4 Receipt of service income 3,36,14,586 5 Sale of components 1,20,580 6 Import of demo/loaner jigs tools forming part of fixed assets 4,91,01,078 7 Provision for market support serv ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... same for the purpose of comparison of the AMP expenditure as under: S. No. Name of comparables AMP expenditure Sales turnover AMP/Sales(5) 1. ADS Diagnostic 923746 73624772 1.25 2. Frontline Electro 2223055 207154850 1.70 3. Satyatej 5977174 71287763 8.38 4. Advanced Micronic 2871485 213873831 1.34 5. Confident Sales India 4088844 361570828 1.13 Average AMP/Sales ratio in case of comparable companies 2.64 2.4 The learned TPO observed that intensity of the AMP spent by the assessee is much higher than that of comparables taken by the assessee, and accordingly the AMP expenses over and above similar expenses by the comparable ent ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... markup at the rate of 12.82% (₹ 52,02,657/-) for the AMP activities and thus, he worked out the net adjustment of ₹ 4,57,85,009/- following the bright line test on protective basis. 2.7 The learned TPO alternatively also proposed substantive adjustment using cost plus method, following the decision of the Hon ble Delhi High Court in the case of Sony Ericsson Mobile Communications India Pvt. Ltd. Vs. CIT, ITA No.16/2014 (order dated 16.03.2015) as under : Total Expenditure on AMP by the assessee 8,57,15,671 Mark-up @ 12.82% 1,09,88,749 Adjustment u/s 92CA 9,67,04,420 2.8 Accordingly, the learned TPO proposed adjustment of ₹ 9,67,04,420/-on substantive basis. 2.9 In the draft assessment order issued on 12/12/2017, the learned Assessing Officer included the addition for transfer pricing adjustment of ₹ 9,70,55,020/- on substantive basis and ₹ 4,57,85,009/-on protective basis. 2.10 Aggrieved, the assessee filed objection before the learned DRP. After considering submission of the assessee, the learned DRP noted that the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... basis. 5.1 Before us, the learned counsel of the assessee filed two paper books containing pages 1 to 551 and page 1 to 686 respectively. The learned counsel referred to the page 2 of order of the learned TPO, wherein it is mentioned that the assessee in its transfer pricing study has characterized itself as a distributor of group s products in India. The learned counsel submitted that during the year assessee, against sales turnover of approximately ₹ 170 crore and profit of ₹ 20.71 crores, have incurred AMP expenses of approximately 6 crores only, which comes to approximately 5% of the sales turnover. According to the learned counsel, the AMP expenses have been incurred for augmenting sales revenue of the product sold by the assessee and not for the brand promotion as alleged by the Ld. TPO. The learned counsel referred to page 34 of the order of TPO wherein detail of expenses of ₹ 8,57,15,671/- incurred on AMP have been analyzed by the learned TPO. According to the learned counsel, the expenses have been incurred mainly on conference and seminar s, demo and loaner expenses and sales promotion expenses, which in any way has not benefited the brand of the AE. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Ld. DR referred to page 199 of the paper-book and submitted that the reference to the transaction of the purchase of finished goods, consumable, accessories for demo and loan items, the AE has partly undertaken business risk, inventory risk and foreign-exchange risk, whereas the entire product liability risk is with the AE. Thus according to the Ld. DR it is wrong to assume that assessee is a full-fledged distributor, immune to various risk associated with the transactions. The learned DR submitted that by way of sale of products in India, the AE is also benefited and therefore it needed brand building expenses. The learned DR referred to page 8- 652 of the paper book volume II, wherein the assessee has filed details of the AMP expenses. The learned DR referred to page 197 specifically and submitted that name of the Olympus brand was displayed prominently in all conferences/seminar or workshops organised for the doctors and other technical persons. He submitted that the assessee was entitled for distribution commission on sale of the products whereas the AE who has manufactured the products would be benefited more as compared to the assessee. He referred to page 173 of the paper ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... well as to its AEs in Bangladesh, Nepal Bhutan and Sri Lanka. The said assessee was granted a non-transferable, royalty free license for the use of trademarks of the AE in India. The said assessee characterized itself as a full-fledged manufacturer exposed to all kinds of risk associated with carrying out such business. The Tribunal (supra) referred to provisions of section 92B, relevant explanation to section 92B and clause (v) of section 92F of the Act with regard to the issue of what is an international transaction. After appreciating various provisions of the Tribunal observed in para 53 as under: 53 .. This definition of transaction has to be read in conjunction with the definition given in section 92 B, which means that the transaction has to be first in the nature given in Section 92B (1); and then when such transaction includes any kind of arrangement, understanding or action in concert amongst the parties, whether in writing or formal, then too it is treated as international transaction, Here the conjoint reading of both the sections lead to an inference that in order to characterized as international transaction, it has to be demonstrate ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Mere fact of excessive AMP expenditure cannot establish the existence of such a transaction. It is only when such a transaction is established then perhaps it may be possible to bench mark it separately. Under the Indian Transfer Pricing provisions, it has been well established over the period of time that detailed FAR analysis has to be carried out to identify all the functions of resident tax payer company and the non-resident AEs pertaining to all the international transactions like purchase of raw material, payment of royalty, purchase of finished goods, export of finished goods, support services or whether there is any direct sales by AE in India. Further it needs to be seen, whether marketing activities relating to DEMPE functions reflected in any such expenditure incurred by the resident tax payer company and the non-resident AE in India are in conformity with the functions and risk profiles and the benefit derived by the tax payer company and the AE. It is also very relevant to examine, whether the AE is assuming any kind of risk in the Indian market or is benefitting from India in one way or the other. Thus, FAR analysis is the key which needs to be seen what kind of f ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... assessee has reported various risk associated with the transaction of purchase of products by the assessee as under: Type OMSI (the assessees) AEs Business risk Yes Yes Inventory risk Yes Yes Product liability risk No Yes Warranty risk Yes No Credit and collection risk Yes No Foreign exchange risk Limited Yes 5.8 Thus, we find that along with the business risk and inventory risk shared with the assessee, the AE was subjected to hundred percent product liability risk. The relevant clause of the productivity risk on page 198 of the paper book-I reads as under: 4.1.3.3 Product liability risk Product liability risk refers to the risk associated with failure of a product or the possibility of facing legal action from customers due to defects in the products provided. In case of inherent defaul ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... rt in para 118 has considered the cases of the entities engaged in distribution and marketing functions in India and observed that Indian entity i.e. the distributor must be compensated by adhering to the arm s-length price, which is the core of transfer pricing adjudication. The relevant finding of the Hon ble High Court is reproduced as under: 118. The Indian subsidiaries in the present case are engaged in distribution and marketing functions of the products manufactured by foreign AEs and in some cases, products are also manufactured by them under license in India. Figure 2.1 refers to the value chain analysis, and treats marketing' and distribution' as two headings, but this does not mean that marketing and distribution functions cannot be combined and treated as one package or a bundle. The functions performed could be both marketing and distribution. Marketing in the form of sale promotion, advertisements, etc. would necessarily involve expenditure both in terms of third party expenditure which the Indian assessee would liable to incur, as also towards the office maintenance and other overhead expenses. Even as one package or a bundle, the Indian subsidiary, i.e. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... er, the arm's length computation made both by the assessee as well as the TPO must take into account the AMP expenses. 6.2 Further, the Hon ble High Court has discussed as how a pure or a simple independent distributor or a distributor having low-risk should be compensated. The relevant finding of the Hon ble High Court is reproduced as under: 124. There is a difference between a pure and a simple independent distributor and a distributor with marketing rights. An independent distributor with a full marketing right is a person or an entity legally independent of the manufacturer, who purchases goods from the manufacturer for re-sale on its own accounts. The transaction between the two is a straightforward sale in which the distributor takes all economic risk of product distribution and ultimately gains or makes loss depending upon market and other conditions. The manufacturer is not concerned. In case of a low or no risk distributor and he virtually acts as an agent for the loss and gain is that of the manufacturer. There is no economic risk on distribution of profits. He is, therefore, entitled to fixed remuneration for the self efforts, i.e., relating to the task or f ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... mark or brand profit or services of the parent company in India, customer loyalty and the brand existence of dealer network whether the Indian entity is to provide after sales service the support, market and customer details, etc. It acknowledged that the stand of the Indian tax authorities, who have applied the concept of ‗bright line test' of no risk or limited risk distributor or to determine non-routine expenses, has led to multifarious challenges on several account. However, it stands recorded in sub- paragraph No.18 that the important issue in determination of arm's length price is to examine the benefits of the AMP expenditure and whether Indian entities do not receive share of excess profits related to local marketing intangible. Accordingly, the claim of the Revenue is that extraordinary AMP expenditure does not result in appropriate enhancement of profitability of Indian subsidiary or related party. The question, therefore, when a subsidiary entity engaged in distribution and marketing incurs AMP expenses, is to ascertain whether the subsidiary AE entity has been adequately and properly compensated for undertaking the said expenditure. Such compensation may ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... on 92C. 10B. (1) For the purposes of sub-section (2) of section 92C, the arm's length price in relation to an international transaction or a specified domestic transaction shall be determined by any of the following methods, being the most appropriate method, in the following manner, namely :-- (a) xxx (b) Resale Price Method, by which,-- (i) the price at which property purchased or services obtained by the enterprise from an associated enterprise is resold or are provided to an unrelated enterprise, is identified; (ii) such resale price is reduced by the amount of a normal gross profit margin accruing to the enterprise or to an unrelated enterprise from the purchase and resale of the same or similar property or from obtaining and providing the same or similar services, in a comparable uncontrolled transaction, or a number of such transactions; (iii) the price so arrived at is further reduced by the expenses incurred by the enterprise in connection with the purchase of property or obtaining of services; (iv) the price so arrived at is adjusted to take into account the functional and other differences, including differences in accounting practices, if any, betw ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... f the purchased property or services obtained by the assessed from the AE. 160. RP Method postulates reverse calculation, as it first requires identification and ascertainment of resale price, then reductions and adjustment. It hypothesises ascertainment of normal gross profit margins of comparables including, if required, adjustment on account of functional and other differences with comparables. Uncontrolled transaction is comparable with the controlled transaction for the purpose of RP Method, only if two conditions are satisfied: that there is no difference between the functions, which would materially affect the normal gross profit margins in the open market; and reasonably accurate adjustments can be made to eliminate material effect of such differences. RPMethod may require fewer adjustments on account of product differences in comparison to the CUP Method, i.e. Comparable Uncontrolled Price Method because minor product differences are less likely to have material effect on the profit margins as they do on the price. Compensation for performing similar functions tends to equalise across different activities, whereas in case of products, the equalisation is normally possib ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... sale price margin could be higher where it can be demonstrated that the reseller has some special expertise in the marketing of such goods, in effect bears special risks, or contributes substantially to the creation or maintenance of intangible property associated with the product. However, the level of activity performed by the reseller, whether minimal or substantial, would need to be well supported by relevant evidence. This would include justification for marketing expenditures that might be considered unreasonably high; for example, when part or most of the promotional expenditure was clearly incurred as a service performed in favour of the legal owner of the trademark. In such\a case the Cost Plus method may well supplement the RP Method. 161. The United Nations' Manual on RP Method highlights that this method is based upon arm's length gross profits, rather than directly determining arm's length prices. As compared to CUP Method, RP Method requires less direct transactional (product) comparability than CUP Method. However, there must be functional comparability. A similar level of compensation is expected for performing similar functions across different activ ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... incurred considerable (not necessarily extra-ordinary or non-routine) AMP expenses. The reason is obvious; there is no comparability analysis possible. In such cases, it is not possible to examine and compare the functional comparability between the controlled tested transaction and uncontrolled internal party transaction on account of AMP expenses. Internal comparable would not account for the credible gross profit rate, which an AE should be ensured when it incurs AMP expenses. Functionally the comparable is merely a manufacturer and thus, the said function is compared. AMP expenses do not get factored and compared. As an abundant caution, we would still add that where adjustments clause (iv) can give reliable and accurate results, internal comparables could still be applied. This would likely happen, when AMP expenses are insignificant in quantum. 163. Thus, in such cases, external comparables where said parties are performing similar functions including AMP expenses would give more accurate and precise results. 164. However, it would be wrong to assert and accept that gross profit margins would not inevitably include cost of AMP expenses. The gross profit margins could r ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ible to make adjustments, then RP Method may not be the most appropriate and best method to be adopted. 167. Before us, the Revenue has not pleaded or submitted that the RP Method should not have been adopted. The TPO and the Assessing Officer did not reject the RP Method adopted by the assessee. The assessed submit that the Revenue accepts functional parity and in fact, without adjustment. Contra, Revenue would argue that the Assessing Officer/TPO and the Tribunal have adopted and applied the CUP Method for determining arm's length price of AMP expenses. We do not pronounce a firm and final opinion on the said lis as it should be at first examined by the Tribunal. 168. The Tribunal has upheld adoption of CP Method after applying bright line test' in the case of Reebok India Co. Ltd. and Canon India Pvt. Ltd. The ‗bright line test' adopted to demarcate the routine and non-routine AMP expenditure is predicated on selection of a domestic distributor and marketing company that does not own intangible brand rights. Contract value would be treated as NIL. In terms of our finding recorded above, the said finding would not be correct. The approach and procedure for ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... profit is defined as sales minus cost of goods sold. The said method is strictly applied to manufacturing or assembling activities or relatively simple service providers. Like RP Method, CP Method is a gross margin method as it attempts to derive the arm's length price on a mark-up of cost of goods or services provided. 171. Determination of cost or expense can cause difficulties in applying CP Method. Careful consideration should be given, what would constitute cost i.e. what should be included or excluded from cost. A studied scrutiny of CP Method would indicate that when the said Method is applied by treating AMP expenses as an independent transaction, it would not make any difference whether the same are routine or non-routine, once functional comparability with or without adjustment is accepted. The gross profit of the comparable is applied and accepted, when there is no difference between the AMP and other functions being compared that would materially affect the gross profit mark up or when reasonably accurate adjustments can be performed. Thus, CP Method requires functional comparability. This comparability analysis would necessarily imply that the comparable must ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... fter correcting the negative impact, if any, of the controlled conditions. Therefore, if entire marketing and distribution expenses, or marketing or AMP expenses are bench marked under CP Method, then it would be injudicious and irrational to apply any other method to compute the arm's length price of a larger composite international transaction, of which the said costs and expenses form only a part. Logically, if the costs or expenses as a function are excluded or included in the cost while computing the arm's length price under the CP Method, the gross profit as a result of such transaction would be lower or higher. This situation would be different from subjecting the same international transaction to arm's length pricing by two different methods, which is permissible, in the manner stipulated in the first Proviso to Section 92C of the Act. 6.7 In view of the aforesaid discussion, we hold that International transaction of AMP functions exists in the case of the assessee, however, as far as benchmarking of the said transaction is concerned, we find that the Ld. Transfer Pricing Officer has claimed to have followed the directions of Hon ble Delhi High Court in the ..... X X X X Extracts X X X X X X X X Extracts X X X X
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