2018 (2) TMI 1639 - AT - Income Tax

Taxpayer classified as business support services provider, not trader. FOB value not included in costs.

The Tribunal upheld the CIT (A)'s decision, ruling that the taxpayer is a business support services provider, not a trader. The inclusion of Free on Board ... Addition on account of difference in Arm’s Length Price - characterization of the business function of the taxpayer - whether the taxpayer is a business support services provider or a trader and the FOB value of goods sourced from India by the taxpayer is to be included in the operating cost of the taxpayer in order to compute its margin? - Held that:- In view of the undisputed fact that AEs of the taxpayer is into trading activities of various products, such as, textiles, machinery, information and communications related products, metals, products related to oil and other energy resources, general merchandise chemicals, provisions and food and the taxpayer is merely rendering business support services to these AEs in the form of facilitation services to source goods from India. So, the limited activities carried out by the taxpayer for its AEs in the nature of licensing and facilitation of business of its AEs separates the taxpayer from the Sogo Shosha traders. When the taxpayer is not proved to be a risk bearer in the nature of credit risk, price risk, inventory risk, storage and handling risk etc., it cannot be treated as a trader. Moreover when undisputedly the taxpayer has not developed any intangible or accorded locational savings to its AEs and has earned net operating profit margin on cost of 129.34% against the margin of comparable at 14.05%, it cannot be said that the taxpayer has not been adequately compensated. As has been held in Li & Fung India Pvt. Ltd. (2014 (1) TMI 501 - DELHI HIGH COURT) the determination of 2.58% margin over the FOB value of the AEs contract not sustainable in the eyes of law. Rather TPO has artificially enhanced the cost base of the taxpayer and proposed a mark up of the FOB value of goods sourced by AEs and as such this approach is not available in TNMM under Rule 10B(1)(e) of the Act. So, the TPO has wrongly recharacterized the business function of the taxpayer from a business support service provider to a trader. - Decided against revenue 1. ISSUES PRESENTED AND CONSIDERED * Whether the taxpayer is to be characterized as a business support services provider or as a trader for transfer-pricing purposes. * Whether the Transfer Pricing Officer (TPO) was entitled to include the Free on Board (FOB) value of goods sourced by Associated Enterprises (AEs) in the taxpayer's operating cost for computation of net margin under the Transactional Net Margin Method (TNMM) / Rule 10B(1)(e). * Whether recharacterisation of the taxpayer's functions and the selection of trading comparables (and consequent adoption of a markedly lower comparable margin) was permissible in light of the taxpayer's functional profile and prior consistent treatment. 2. ISSUE-WISE DETAILED ANALYSIS Issue 1 - Characterisation: business support services provider vs trader Legal framework: * Transfer-pricing assessment under the statute requires functional and risk analysis to determine the rol e of the enterprise in international transactions; appropriate application of TNMM under Rule 10B(1)(e) depends on costs, sales or assets 'of the enterprise'. Precedent treatment: * The Tribunal relied on an authoritative High Court decision addressing identical facts where a captive sourcing/sub-contracting enterprise was held to be a limited-risk sourcing/service provider rather than a trader; that decision rejected imputation of third-party manufacturing/export costs to the service provider. Interpretation and reasoning: * The taxpayer rendered limited functions: arranging meetings, interacting with officials, providing market information, arranging feasibility studies and facilitating sourcing - described as licensing and facilitation activities. * The taxpayer did not bear enterprise risks characteristic of trading (credit risk, price risk, inventory, storage/handling), had not invested in manufacturing/working capital, had not developed intangibles, and did not confer locational savings to AEs. * Functional and risk profile thus differed materially from trading concerns; limited-risk, captive support function was established on the record. Ratio vs. Obiter: * Ratio: The determination that a taxpayer performing limited facilitation/support functions and not bearing trading risks must be characterized as a business support services provider for TP purposes, not a trader. This guides proper selection of comparables and application of TNMM. Conclusions: * The TPO's recharacterisation of the taxpayer as a trader was not sustainable on the facts; the taxpayer is a business support services provider and should be treated as such for transfer-pricing analysis. Issue 2 - Inclusion of third-party FOB value in taxpayer's operating cost under TNMM Legal framework: * TNMM under Rule 10B(1)(e) requires computation of the net profit margin 'realised by the enterprise from an international transaction ... in relation to costs incurred or sales effected or assets employed by the enterprise'. The method contemplates reference to the enterprise's own factors. Precedent treatment: * The High Court precedent (with identical facts) held that augmenting the taxpayer's cost base by the cost of manufacture/export incurred by unrelated third-party vendors and applying a mark-up on FOB value was outside the TNMM framework and impermissible. Interpretation and reasoning: * TNMM mandates calculation of net margin relative to the taxpayer's own costs; imputing costs incurred by third parties (manufacture/export) is textually unsupported. * The TPO's method (including FOB of goods sourced by AEs in the taxpayer's operating cost and applying a mark-up on that FOB) effectively imputed notional income, broadened the base improperly, and introduced a cost component alien to the taxpayer's activities. * Given taxpayer did not incur the manufacturing/export costs and did not perform those activities, attribution of such costs to compute its TNMM margin was impermissible. Ratio vs. Obiter: * Ratio: Under TNMM/Rule 10B(1)(e), only costs, sales or assets of the taxpayer may be used to compute its net margin; costs of unrelated third parties cannot be imputed to the taxpayer for that purpose. Conclusions: * Inclusion of FOB value of goods sourced by AEs in the taxpayer's operating cost for TNMM computation was not lawful; the TPO's adjustment based on such inclusion was incorrect and liable to be deleted. Issue 3 - Selection of comparables and consistency of transfer-pricing treatment Legal framework: * Proper comparability analysis requires selection of entities performing similar functions and bearing comparable risks; revenue authorities should respect consistent prior treatment absent relevant changes in facts or business model. Precedent treatment: * Coordinate Tribunal and High Court decisions with identical or similar facts upheld treatment of similarly situated taxpayers as service providers and rejected adjustments that broadened cost base to include third-party FOB values. Interpretation and reasoning: * The taxpayer adopted TNMM with comparables showing an average margin of 14.05% against the taxpayer's margin; the TPO recharacterised the business and selected trading comparables yielding a 2.58% margin, producing a large adjustment. * There was no evidence of change in the taxpayer's business model; prior assessments and later years were accepted by Revenue under the same functional analysis, invoking the rule of consistency. * Recharacterisation and selection of trading comparables ignored the taxpayer's limited functions and risk profile and was therefore improper. Ratio vs. Obiter: * Ratio: Comparability and margin selection must align with the taxpayer's actual functional and risk profile; absence of business-model change militates against unilateral departure from prior accepted analyses. Conclusions: * The TPO's choice to treat the taxpayer as a trader and to select trading comparables was unwarranted; the resultant adjustment based on a markedly different comparable set was not sustainable. Cross-reference * Issues 1 and 2 are interlinked: characterisation as a trader was the basis for including third-party FOB in the cost base (Issue 1 ? Issue 2). Correct characterisation as a limited-risk service provider forecloses the TPO's cost-broadening approach under TNMM. Final disposition (legal conclusion) * The TPO's recharacterisation and consequent ALP adjustment were legally unsound; deletion of the addition is warranted. The Revenue's appeal against deletion of the adjustment is dismissed. (Ratio findings stated above constitute the operative legal conclusions.)