2015 (3) TMI 613 - HC - Income Tax

High Court: Functions and costs determine cost base, not third-party vendors. Remand for redetermination.

The commissioner of income tax-II Versus li &fung (india) pvt. Ltd.

The High Court held that the ITAT's order directing a fresh determination of the addition on account of Arm's Length Price for the Assessment Years ... Correctness of the ITAT’s order - directing the AO/TPO for fresh determination of the addition originally made on account of Arm’s Length Price, which was specified in the course of the proceedings - Held that:- Question of law urged in both the appeals does not arise since it already stands settled in the previous order reported in [2014 (1) TMI 501 - DELHI HIGH COURT] - pertaining to the present assessee wherein held that there is no legal authority under the Income Tax Act, 1961 or the Rules to broaden the cost base in that manner. Consequently, the ITAT directed a remission of the matter to the AO for redetermination of the cost base. The TPO’s reasoning to enhance the assessee’s cost base by considering the cost of manufacture and export of finished goods, i.e., ready-made garments by the third party venders (which cost is certainly not the cost incurred by the assessee), is nowhere supported by the TNMM under Rule 10B(1)(e) of the Rules. Having determined that (TNMM) to be the most appropriate method, the only rules and norms prescribed in that regard could have been applied to determine whether the exercise indicated by the assessee yielded an ALP. The approach of the TPO and the tax authorities in essence imputes notional adjustment/income in the assessee’s hands on the basis of a fixed percentage of the free on board value of export made by unrelated party venders. Appeal dismissed. ISSUES PRESENTED AND CONSIDERED 1. Whether the Tribunal correctly directed remittal to the Assessing Officer/Transfer Pricing Officer for fresh determination of an addition made on account of Arm's Length Price (ALP) where the AO/TPO had broadened the cost base used under the Transactional Net Margin Method (TNMM) by including costs not incurred by the assessee. 2. Whether Rule 10B(1)(e) (TNMM) permits imputing or incorporating costs incurred by unrelated third-party vendors or associated enterprises into the assessee's cost base for computing net profit margin and determining ALP. ISSUE-WISE DETAILED ANALYSIS Issue 1 - Competence of AO/TPO to broaden the assessee's cost base under TNMM Legal framework: The TNMM, as embodied in the relevant transfer pricing rule, requires computation of the net profit margin 'in relation to costs incurred or sales effected or assets employed' by the enterprise whose ALP is being determined. The method compares net margin realised from international transactions with that of comparable uncontrolled enterprises. Precedent treatment: The Court relies on its prior decision holding that the textual language of the rule contemplates reference to the enterprise's own costs, sales or assets and does not authorize imputation of costs of third parties or associated enterprises to expand the assessee's cost base. Interpretation and reasoning: The rule's text ('in relation to costs incurred ... by the enterprise') is read narrowly and purposively to confine the cost base for TNMM to costs actually incurred by the assessee. Enhancing the assessee's cost base by incorporating the manufacturing/export costs of unrelated third-party vendors (or costs of an associated enterprise) changes the reference against which the assessee's net profit margin is computed and is not supported by the TNMM framework. Such an approach effectively imputes notional income by applying a percentage to a larger value base (e.g., FOB value of unrelated vendors' exports), which the TNMM does not permit. Ratio vs. Obiter: The determination that the AO/TPO cannot broaden the cost base in the manner described is treated as ratio decidendi applicable to the proper application of TNMM under the rule. Conclusion: The AO/TPO's enlargement of the assessee's cost base by including costs not incurred by the assessee was not legally permissible under the TNMM rule and therefore any addition based on that broadened base required reassessment consistent with the correct interpretation. Issue 2 - Correctness of the Tribunal's direction to remit for redetermination in light of earlier authoritative ruling Legal framework: Where a question of law is settled by a binding prior pronouncement of the Court on the interpretation of the transfer-pricing rule and its permissible application, tax authorities must act in conformity with that interpretation in subsequent assessments involving the same issue. Precedent treatment: The Tribunal remitted the matter to the AO for redetermination of the cost base in accordance with the Court's earlier interpretation confining the cost base to costs incurred by the assessee. The Court endorses that approach as consistent with the settled legal position. Interpretation and reasoning: Because the issue in the present appeals involves the same interpretive point - whether costs of third parties/AE may be included in the assessee's cost base for TNMM - and that point has already been resolved against such enlargement, there was no substantive question of law remaining to be decided afresh. Remittal for reassessment in conformity with the settled rule was appropriate; the Tribunal's direction followed directly from the Court's prior legal determination. Ratio vs. Obiter: The conclusion that the Tribunal's remission was correct in light of binding precedent is ratio with respect to the application of precedent to subsequent assessments on the same question. Conclusion: The Tribunal correctly directed remittal for redetermination of the cost base, and no new legal question arose; the assessment must be reworked consistent with the rule that TNMM margin calculations reference only costs incurred by the assessed enterprise. Cross-references 1. The analysis of Issue 1 is dispositive of Issue 2: because the rule confines the cost base to the assessee's costs, the Tribunal's remittal to give effect to that interpretation was warranted. 2. Any addition or adjustment premised on a broadened cost base that includes third-party or associated-enterprise costs is unsupported by the TNMM rule and must be revisited by the AO/TPO in conformity with the Court's interpretation. Disposition The Tribunal's direction for reassessment in conformity with the Court's prior interpretation (restricting the TNMM cost base to costs incurred by the assessee) is upheld; the appeals presenting no new question of law are dismissed.