2015 (11) TMI 788 - AT - Income Tax

Tribunal allows markup on operational costs, no transfer pricing adjustment needed

GAP International Sourcing (India) Pvt. Ltd. Versus DCIT, Circle 10 (1), New Delhi

The Tribunal ruled in favor of the assessee, determining that the markup of 15.36% on operational costs was appropriate and aligned with previous ... Transfer pricing adjustment - TOP held that the correct compensation model at arm’s length price, in this case, would be commission of FOB cost of goods sourced from India - Held that:- In view of the enunciation of law by the Hon’ble jurisdictional High Court in the case of Li & Fung India Pvt. Ltd. order dated 16.12.2013, there remains no doubt whatsoever that the base of “total cost” as adopted by the TPO and approved by the DRP in considering the FOB value of goods between the third party enterprises cannot be accepted. Ex consequenti, the “total cost” being the denominator in the PLI of OP/TC, has to be taken as the cost incurred by the assessee and not the FOB value of goods between third party enterprises sourced through the assessee. In other words, the tested party should be the assessee and not its AE. Thus, we hold that the assessee is entitled to cost plus form of remuneration and not a commission based remuneration. See case of Li & Fung India Pvt. Ltd. [2014 (1) TMI 501 - DELHI HIGH COURT] There is no necessity of any TP adjustment. Even further, for the current year, we note that both as per the comparables chosen by the assessee which yield a markup on 11.66% on operating cost and also the comparables chosen by the TPO, which yield 18.06% on operating cost, after making necessary working capital adjustment, indicates that the assessee’s markup of 15.36% charged on its operating cost falls well within the arm’s length price after considering the range of +/- 5% as envisaged in the Proviso to section 92C (2) of the Act. Therefore, no TP adjustment is required in assessee’s case. - Decided in favour of assessee. ISSUES PRESENTED AND CONSIDERED 1. Whether the appropriate transfer pricing methodology for a wholly owned local subsidiary providing sourcing/support services to its foreign enterprise is the Transactional Net Margin Method (TNMM) with Operating Profit/Total Cost (OP/TC) as the profit level indicator, or a commission-based remuneration measured as a percentage of FOB value of goods sourced. 2. Whether the transfer pricing adjustment computed by applying an average commission percentage on FOB value of goods (as adopted by the Transfer Pricing Officer) is permissible under the Act and Rules where the tested party performs limited, preordained, non-risk bearing procurement facilitation functions governed by vendor handbook and AE directions. 3. Whether comparables and working capital adjustments relied upon by the tax authorities to derive an ALP outside the assessee's reported OP/TC fall within the arm's length range under the Proviso to Section 92C(2) of the Act. ISSUE-WISE DETAILED ANALYSIS Issue 1: Appropriate Transfer Pricing Method and Profit Level Indicator Legal framework: The Act and Transfer Pricing Rules require selection of the most appropriate method for determining arm's length price. TNMM is accepted where functions performed do not justify using margin on transaction value; OP/TC is an accepted profit level indicator for service providers. Precedent treatment: Coordinate Tribunal decisions for the same taxpayer in prior assessment years applied TNMM with OP/TC and adopted a cost-plus remuneration; a jurisdictional High Court decision in a similar fact situation criticized use of FOB-based denominator and endorsed cost-based measures. Interpretation and reasoning: The Tribunal examined the factual matrix - the local entity's role limited to sourcing support, following detailed directives (designs, quality parameters, vendor terms) contained in AE's vendor handbook. These facts demonstrate preordained, non-risk bearing procurement facilitation rather than independent entrepreneurial functions. Accordingly, a PLI based on the tested party's costs (OP/TC) better reflects the economic reality than a margin on AE's FOB contract value. Ratio vs. Obiter: Ratio - Where the tested party executes vendor handbook directives and undertakes non-risk bearing sourcing support, TNMM with OP/TC is the appropriate method; reliance on FOB value of AE's contracts as denominator is inappropriate. Conclusion: The appropriate method is TNMM with OP/TC as PLI; cost-plus form of remuneration should be adopted, not commission on FOB value. Issue 2: Validity of Commission-Based Remuneration on FOB Value Legal framework: Adjustments must be supported by objective factual analysis demonstrating why the reported TP method is unacceptable; Section 92C(2) and relevant judicial standards require reasoned findings relating to functions, assets and risks. Precedent treatment: The jurisdictional High Court decision criticized broad basing of profit denominator on FOB value and held such an adjustment contrary to law where the tested party did not bear significant risks or enjoy locational advantages; previous Tribunal orders in the taxpayer's own cases distinguished commission models on similar facts. Interpretation and reasoning: The Tribunal applied the principle that tax administrators must base conclusions on specific facts. The TPO's adoption of a commission model and application of average distributor margins on FOB was not justified on the record, given the assessee's constrained role and documented AE control. The High Court's reasoning that vague assertions of 'significant risk' without demonstrable material are insufficient was followed. Hence, the TPO's model lacked foundation. Ratio vs. Obiter: Ratio - Rejection of commission on FOB where the tested party's activities are preordained and non-risk bearing; requirement that tax authorities justify adoption of a fundamentally different remuneration base with concrete factual findings. Conclusion: Commission-based remuneration measured as a percentage of FOB value of goods sourced is not permissible on these facts; no TP adjustment on that basis should be made. Issue 3: Selection and Adjustment of Comparables and Arm's Length Range under Proviso to Section 92C(2) Legal framework: TNMM benchmarking requires selection of appropriate comparable companies and, where applicable, working capital adjustments; the Proviso to Section 92C(2) allows consideration of a range of +/- 5% around the median for determining ALP. Precedent treatment: Earlier Tribunal orders for the taxpayer accepted higher cost-plus markups (e.g., 32-34% in certain years) but also recognized that, following the High Court decision in a similar matter, a conservative cost-plus margin (e.g., 5% in the cited precedent) may be acceptable for comparator assessment; the Tribunal for the prior year applied the High Court's approach to find the taxpayer's actual 15.36% markup conservative. Interpretation and reasoning: The Tribunal compared OP/TC metrics derived from both the assessee's chosen comparables (mean 11.66%) and TPO's comparables after working capital adjustment (yielding 18.06%). The assessee's reported OP/TC of 15.36% lies within the composite arm's length range when +/-5% variation is applied per the Proviso to Section 92C(2). Given (a) appropriateness of OP/TC as PLI, and (b) comparables' ranges, the assessee's margin is within ALP and no upward adjustment is warranted. Ratio vs. Obiter: Ratio - Where the tested party's OP/TC falls within the arm's length range derived from appropriate comparables (after permissible adjustments and application of Section 92C(2) proviso), no TP adjustment is required. Conclusion: The comparables invoked by TPO do not justify an ALP outside the statutory range; the assessee's 15.36% OP/TC is within the arm's length range and no adjustment is required. Cross-References and Consolidated Outcome 1. Issues 1-3 are interrelated: correct identification of functions and risks (Issue 1) negates the rationale for a FOB-based commission model (Issue 2), which in turn affects selection/interpretation of comparables and the arm's length range (Issue 3). 2. Applying these principles, and respectfully following coordinate bench precedent and the jurisdictional High Court's enunciation on the inadmissibility of basing remuneration on AE's FOB without factual basis, the Tribunal held that no transfer pricing adjustment was warranted and allowed the appeal.