2015 (1) TMI 193 - AT - Income Tax

Tribunal remands Transfer Pricing, upholds R&D expense treatment as revenue.

Wrigley India Pvt. Ltd. Versus Assistant Commissioner of Income Tax

The Tribunal allowed the appeals filed by the assessee for statistical purposes, remanding the matter to the Transfer Pricing Officer for fresh ... Transfer pricing adjustment – Correctness of ALP adjustment – Method of determination of ALP - Whether Cost Plus Method (CPM), with entrepreneurship profits derived from manufacturing and selling its products in India as the benchmark, would indeed be most appropriate method of determining the arm’s length price (ALP) of contract manufacturing of its same products for its associated enterprises abroad – Held that:- The two situations, i.e. sale simplictor of a FMCG product for an overseas AE without any costs being incurred on the marketing and sales promotion amongst the end users, and sale of a FMCG product to a domestic independent enterprises with full responsibilities for marketing and sales promotion amongst the end users, are not ‘comparable transactions’ in the sense that profitability in the latter cannot be a proper benchmark for profitability in the former - however, the comparability analysis has been confined to the first segment itself, i.e. characteristic of the property transferred - the product comparability is an important factor but it’s certainly not the sole or decisive factor - the assessee was producing the same products for its AEs as it was producing for independent enterprises but that was all so far as similarities were concerned - The FAR profile was not the same, the contract terms were not the same, the economic circumstances were not the same and the business strategies were not the same - necessary precondition for application of CPM, i.e. finding normal mark up of profit in comparable uncontrolled transactions, could not have been fulfilled - when uncontrolled transactions were not comparable, the normal mark up on profit on such transactions could not have been relevant either. The authorities below were not justified in holding that the cost plus method was the most appropriate method on the facts of this case - one of the necessary ingredient for application of CPM, i.e. normal mark up of profit in the comparable uncontrolled transactions- whether internal or external, was not available as no comparable uncontrolled transactions were brought on record by the authorities below - What was brought on record as an internal comparable uncontrolled transaction, i.e. manufacturing for the domestic independent enterprises, was uncomparable as the FAR profile was significantly different - there is no reason to disturb the TNMM method adopted by the assessee. Thus, on the facts of the case, the ALP of international transactions with the AEs is to be determined on the basis of TNMM and the ALP adjustments on the basis of CPM is to be vacated – the matter is required to be examined afresh by the TPO and the assessee will be at liberty to justify the ALP determination under the TNMM on such basis as he may deem appropriate and to make all such submissions and to furnish all such evidences in support of thereof, as he may deem fit and proper, and that the TPO will be required to deal with such contentions, submissions and evidences, by way of a speaking order, in accordance with the law and after giving a fair and reasonable opportunity of hearing to the assessee – thus, the matter is remitted back to the TPO for fresh examination – Decided in favour of assessee. Treatment of expenses on research and development – Capital in nature or not – Held that:- It is pointed out that the tax implication of the issue is less than permissible threshold limit in two of the AYs but then as the issue is repetitive in nature, it is covered by the exemption clause in the CBDT instructions in this regard - CIT(A) was rightly of the view that these expenses were incurred on “laboratory testing of the products” and were thus routine revenue expenses in nature - “incurring of these expenses has not resulted in creation of any intangible capital asset” – thus, the order of the CIT(A) is upheld – Decided against revenue. Reliability of Audit Report - Held that:- It is somewhat fashionable to criticize the revenue authorities for their lack of objectivity or even inefficiency but what in the world can justify such a pathetic level of professional work relied upon by even the large corporate entities. If the tax judicial system is clogged by frivolous litigation today and if the tax finality still takes decades to reach, these saviours of taxpayers are as much to be blamed for this situation as anybody else. No purpose can be served in reporting by a chartered accountant when such reports do not even point out glaring infirmities in taxpayer’s approach vis -à-vis the transfer regulation, in a comparison of budgeted profits margin with actual profit margins realized by the comparables which is stated to be ascertainment of ALP on the basis of the TNMM. It appears that in an alarming number cases, these audit reports, rather than painting a true and fair picture of the relevant facts, tend to epitomize the art of constant hedging and manoeuvring by the professionals so as they stay within the confines of permissible professional conduct and are yet able to sidestep the inconvenient realities. Issues Involved:1. Arm's Length Price (ALP) adjustment for contract manufacturing transactions with Associated Enterprises (AEs).2. Treatment of research and development expenses as capital or revenue in nature.Issue-wise Detailed Analysis:1. Arm's Length Price (ALP) Adjustment for Contract Manufacturing Transactions with AEs:The primary issue in these appeals pertains to the correctness of the ALP adjustment made to the billing for contract manufacturing by the assessee to its AEs based abroad. The core question is whether the Cost Plus Method (CPM) or the Transactional Net Margin Method (TNMM) is the most appropriate method for determining the ALP of contract manufacturing transactions.The assessee, a subsidiary of a global confectionery company, manufactures and sells products both domestically and to its AEs. The Transfer Pricing Officer (TPO) rejected the TNMM adopted by the assessee, which compared the net margin realized by the assessee with that of comparable companies. Instead, the TPO applied the CPM, using the gross mark-up on costs for domestic sales as the benchmark for exports to AEs, leading to significant ALP adjustments.The Tribunal noted that the essential input for applying CPM is finding a 'comparable uncontrolled transaction.' The domestic sales, which involve substantial marketing and sales promotion efforts by the assessee, were not comparable to the export transactions where such efforts were undertaken by the AEs. The Tribunal emphasized that the two situations-domestic sales with full marketing responsibilities and export sales without such responsibilities-are not comparable due to different Functional, Asset, and Risk (FAR) profiles.The Tribunal concluded that the authorities below were not justified in applying CPM as the most appropriate method due to the lack of comparable uncontrolled transactions. The TNMM, as adopted by the assessee, was deemed appropriate. However, the Tribunal also criticized the quality of the transfer pricing reports and certifications, leading to the remittance of the matter to the TPO for fresh determination of ALP using TNMM.2. Treatment of Research and Development Expenses as Capital or Revenue in Nature:The second issue concerns the disallowance of expenses incurred by the assessee on research and development (R&D) by treating them as capital in nature. The Assessing Officer (AO) had disallowed these expenses, arguing that they resulted in enduring benefits and pertained to the development of new products.The CIT(A) deleted the disallowance, stating that the expenses were incurred on 'laboratory testing of the products' and were routine revenue expenses. The CIT(A) also noted that these expenses did not result in the creation of any intangible capital asset.The Tribunal upheld the CIT(A)'s decision, agreeing that the expenses were routine and did not create any intangible asset or substantial enduring advantage. The Tribunal found no material to dislodge the CIT(A)'s findings and thus declined to interfere with the deletion of the disallowance.Conclusion:The Tribunal allowed the appeals filed by the assessee for statistical purposes, remanding the matter to the TPO for fresh examination of ALP using TNMM. The appeals filed by the Assessing Officer regarding the treatment of R&D expenses were dismissed, upholding the CIT(A)'s decision to treat them as revenue expenses.