2016 (4) TMI 1447 - AT - Income Tax

Tribunal rules in favor of assessee on Transfer Pricing Adjustments and disallowances.

Mitsui & Co. India Pvt. Ltd. Versus DCIT, Circle 6 (1), New Delhi, DCIT, Circle 16 (2), New Delhi

Mitsui & Co. India Pvt. Ltd. Versus DCIT, Circle 6 (1), New Delhi, DCIT, Circle 16 (2), New Delhi - TMI ISSUES PRESENTED AND CONSIDERED 1. Whether the tested enterprise's activities are trading or routine service/commission (facilitation/indenting) for transfer-pricing purposes and whether recharacterisation as trading was justified. 2. Whether costs of goods sold / FOB value incurred by Associated Enterprises (AEs) can be included in the tested enterprise's cost base under TNMM (Rule 10B(1)(e)) to compute ALP. 3. Whether Transactional Net Margin Method (TNMM) with Berry Ratio (OP/TC) is an appropriate Profit Level Indicator (PLI) for benchmarking the tested enterprise's international transactions. 4. Whether the proviso to section 92C (±5% tolerance) applies so as to preclude an ALP adjustment once the computed ALP is within 5% of the price reported by the assessee. 5. Whether comparables selected by the Transfer Pricing Officer (TPO) - largely trading companies - were appropriate vis-à-vis a service provider tested party. 6. Whether disallowance under section 14A/Rule 8D is sustainable where no exempt income is earned in the relevant year. 7. Whether alleged prior period expenditure (not claimed in return) can be disallowed; and whether other expenditure disallowances (service fees; logistics/warehousing) were rightly disallowed under section 37(1) or require remand for fresh adjudication. 8. Whether addition under section 43B (service tax) and withholding tax addition on purchases (section 195) were sustainable. 9. Whether interest and consequential matters follow from the above (consequential grounds). ISSUE-WISE DETAILED ANALYSIS Issue 1 - Characterisation of tested party activity (trading v. service provider) Legal framework: FAR analysis required to determine functions, assets and risks; recharacterisation permitted where facts justify. Precedent treatment: Coordinate Tribunal orders and High Court decisions (Li & Fung line) emphasise fact-specific FAR analysis; recharacterisation requires evidence of undertaking trading risks. Interpretation and reasoning: Record showed tested enterprise did not take title to goods, did not bear inventory, price, credit or warranty risk, did not deploy capital in inventory, and primarily performed facilitation/support functions. The Tribunal relied on a detailed FAR analysis and prior coordinate Bench findings addressing identical facts and concluded activities were routine, preparatory and ancillary - not trading. Ratio vs. Obiter: Ratio - where tested enterprise lacks trading risks and does not perform critical functions, recharacterisation as trader is not warranted; application of trading margins is therefore impermissible. (Followed earlier coordinate Bench ratio.) Conclusion: Recharacterisation as trading was unjustified; the tested party is a low-risk service/commission provider for TP purposes. Issue 2 - Inclusion of AE's cost of goods / FOB value in tested party cost base under TNMM Legal framework: Rule 10B(1)(e)(i) provides that TNMM computes net profit margin in relation to costs incurred, sales effected or assets employed by the enterprise (illustrative, not exhaustive). The tested party's own costs are the starting point for TNMM. Precedent treatment: High Court and coordinate Bench (Li & Fung line; Mitsubishi/Sojitz decisions) held that costs incurred by AEs or third-party vendors cannot be imputed to the tested enterprise for TNMM when it has not incurred them. Interpretation and reasoning: The TPO added AE FOB values to the tested party's cost base to simulate trading margins. Tribunal followed coordinate authority holding such notional additions impermissible: when enterprise does not assume inventory/price risk or perform value-adding functions, including third-party costs is unsupported by TNMM and Rule 10B. The Tribunal also noted that the tested party used AE intangibles and networks; no unique intangibles created by the tested entity justified inclusion. Ratio vs. Obiter: Ratio - costs for TNMM must relate to costs actually incurred by the tested enterprise; notional inclusion of AE costs is legally impermissible. Conclusion: Inclusion of AE cost of sales / FOB value in the tested party's cost base was erroneous; corresponding TP adjustments are unsustainable. Issue 3 - Appropriateness of TNMM and Berry Ratio (OP/TC) as PLI Legal framework: Choice of most appropriate method depends on FAR; Rule 10B(1)(e) allows TNMM and permits use of relevant base (including operating costs) where justified. Precedent treatment: Coordinate decisions endorsed Berry Ratio for low-risk facilitation/indentor activities where tested party has no inventory risk and value addition is limited. Interpretation and reasoning: Given tested enterprise's low-risk facilitation role and absence of inventory/price/credit risk, operating profit to operating costs (Berry Ratio) reflects the economic reality better than OP/TC including AE costs. Rule 10B(1)(e) is illustrative and permits other relevant bases; Berry Ratio was appropriate here. Ratio vs. Obiter: Ratio - for low-risk service/commission entities, Berry Ratio under TNMM is an appropriate PLI; trading PLIs are inapposite. Conclusion: TNMM with Berry Ratio was the correct benchmarking approach; TPO's use of trading PLIs was inappropriate. Issue 4 - Applicability of proviso to section 92C (±5% tolerance) Legal framework: Proviso to section 92C(2) prevents adjustment where the ALP determined (arithmetical mean from comparables) is within ±5% of the price reported by the assessee. Precedent treatment: Proviso applies where ALP is determined (using comparables) and compared to reported price; it is not limited to cases involving different methods. Interpretation and reasoning: The TPO had calculated ALP including AE costs; the Tribunal noted that when ALP and reported price differ by less than 5% (as per TPO's own figures), no adjustment could be made under the proviso. The proviso applies even where multiple comparables are used for mean computation under the chosen method. Ratio vs. Obiter: Ratio - where ALP computed by the TPO (on chosen comparables) is within ±5% of the assessee's price, proviso bars adjustment; TPO cannot first include AE costs for ALP and then ignore the proviso. Conclusion: Even on TPO's figures the proviso would have precluded adjustment; therefore adjustments could not be sustained on that ground either. Issue 5 - Selection of comparables (traders v. service providers) Legal framework: Comparable selection must reflect similarity in FAR; comparables engaged in materially different activities are not appropriate. Precedent treatment: Tribunal jurisprudence requires comparability of functions/risks/assets; applying trading comparables to service entities is improper. Interpretation and reasoning: TPO's comparable set comprised predominantly trading entities whose margins reflect trading risks and functions; given tested enterprise's service profile, those comparables were not functionally comparable. Tribunal found TPO's comparables inappropriate and accepted the tested party's service comparables and multi-year averaging. Ratio vs. Obiter: Ratio - comparables must be functionally comparable; trading companies cannot be used to benchmark low-risk service/commission entities. Conclusion: TPO's comparable selection was incorrect; benchmarking using service comparables and Berry Ratio is appropriate. Issue 6 - Disallowance under section 14A / Rule 8D where no exempt income earned Legal framework: Section 14A disallows expenditure incurred in relation to exempt income; requires actual receipt/receivability of exempt income in the relevant year per High Court precedent. Precedent treatment: High Court held section 14A inapplicable where no exempt income is received/receivable during the year (overruling certain Special Bench authority). Interpretation and reasoning: Assessee earned no exempt income in the years under consideration and had not incurred investment during the year; Tribunal applied the High Court ruling to hold section 14A inapplicable. Ratio vs. Obiter: Ratio - section 14A disallowance requires existence of exempt income in the relevant year; absent such income, Rule 8D/section 14A cannot be invoked. Conclusion: Section 14A disallowances were unsustainable and were deleted. Issue 7 - Prior period expenditure and other s37 disallowances (service fees; logistics/warehousing) Legal framework: Expenses allowable under s37(1) must be wholly and exclusively for business; prior period items depend on whether claimed in return/audit statements. Precedent treatment: Assessing Officer must examine supporting evidence and contractual documentation; subsequent DRP or later year decisions bearing on identical transactions can be persuasive. Interpretation and reasoning: Prior period expense was not claimed in the return/computation; Tribunal held AO erred in disallowing it. Large service fee and logistics disallowances lacked adequate evidentiary consideration; the Tribunal remanded these items to AO for fresh adjudication in light of subsequent DRP findings in later year and after opportunity to be heard. Ratio vs. Obiter: Ratio - AO cannot disallow an item not claimed in return; where evidence/agreements are available but not examined, matter should be remitted for fresh decision. Conclusion: Prior period disallowance deleted; service fee and logistics/warehousing additions restored to AO for fresh adjudication with opportunity to the taxpayer. Issue 8 - Section 43B service tax addition and withholding tax on purchases (section 195) Legal framework: Section 43B requires actual payment for certain deductions; section 195 applies where remittance to non-resident is chargeable to tax in India (e.g., presence of PE of payee). Precedent treatment: Where payee has no PE in India and offshore supply is not chargeable, s195 TDS may not be applicable; DRP decisions in subsequent year held in favour of tested party. Interpretation and reasoning: Assessee conceded one ground (service tax) and did not press it. For withholding tax addition on purchases, Tribunal noted subsequent DRP finding for later year that offshore supplies without PE do not attract s195; matter remanded to AO to decide afresh in light of that position. Ratio vs. Obiter: Obiter/operative remand - factual determination of PE and chargeability is case-specific; remand appropriate where revenue's own later position undermines earlier addition. Conclusion: Service tax ground not pressed (against assessee); withholding tax addition remitted to AO for fresh consideration after hearing. Consequential and relief conclusions 1. Transfer pricing adjustments premised on recharacterisation and inclusion of AE costs set aside - TP grounds allowed in favour of tested party. 2. Section 14A disallowances deleted. 3. Prior period disallowance deleted; certain expenditure additions (service fees; logistics) remitted to AO for fresh adjudication with opportunity to be heard; TDS addition remitted similarly. 4. Interest and other consequential grounds follow from outcomes and were treated as consequential.