2021 (10) TMI 610 - AT - Income Tax

Tribunal overturns TP adjustment, deletes addition, emphasizing incorrect premise & High Court's binding decision.

Ikea Services India Pvt. Ltd. Versus The A.C.I.T., Circle - 12 (2) New Delhi

The Tribunal set aside the TP adjustment made by the Assessing Officer, directing the deletion of the addition of Rs. 43,01,97,828/-. The appeal of the ... TP Adjustment - International transaction pertaining to provision of sourcing support services to its Associated Enterprises ('AEs') - functional profile of the Appellant - characterizing as a trader OR service provider - Whether Appellant has developed human resource and supply chain intangible for its AEs? - HELD THAT:- As entire TP approach was on the premise that the services of the appellant are akin to that of a trader and therefore, the TPO has selected the comparables identifying traders as comparables. We are of the considered view that the TPO has proceeded on an erroneous premise which has resulted into his TP adjustment erroneously. The assessee does not have any market risk, product liability risk, service liability risk, credit risk and price risk. The facts on record show that the assessee does not take part in purchase decisions. In fact, the assessee is not engaged and does not have any legal right to do so, in the activity relating to maintaining any stock of merchandise manufactured by vendors and/or reselling the same to group's retail entities on its own account. In other words, the assessee does not bear any risk associated with carrying/owing/maintaining stock of inventory. The glaring fallacy in the approach of the TPO lies on the fact that he has adopted FOB cost of goods procured from India by the AEs through the assessee as cost base. In our considered view, this approach of the TPO is in complete disregard to the functional profile of the assessee. The assessee operates in a limited risk environment providing routine support services to group entities and accordingly, entitled to be remunerated based on assured return. TPO has not accepted the decision of Li & Fund [2014 (1) TMI 501 - DELHI HIGH COURT]solely on the ground that an appeal has been recommended before the Hon'ble Apex Court. In our considered view, when the operation of the decision of the Hon'ble Jurisdictional High Court has not been suspended or stayed, it was mandatory upon the TPO to follow the binding decision of the Hon'ble Jurisdictional High Court. We set aside the TP adjustment made by the Assessing Officer and direct him to delete the addition - Decided in favour of assessee. ISSUES PRESENTED AND CONSIDERED 1. Whether the taxpayer providing sourcing support services to associated enterprises is to be characterized and remunerated as a limited-risk service provider under the arm's length principle, or as a trader such that the Free on Board (FOB) value of goods sourced should be included in the taxpayer's cost base for transfer pricing under TNMM. 2. Whether, under the Transactional Net Margin Method (TNMM) and Rule 10B(1)(e) of the Rules, costs incurred by associated enterprises or third-party vendors (including FOB value of goods procured) can be imputed to the taxpayer's cost base for computation of its net profit margin. 3. Whether selection of trading entities as comparables is appropriate where the taxpayer's functional profile reflects routine/limited-risk sourcing support services without market, inventory, purchase-decision, price or credit risk. ISSUE-WISE DETAILED ANALYSIS Issue 1 - Characterization and remuneration model (service provider v. trader) Legal framework: Arm's length principle and transfer pricing rules requiring selection of most appropriate method (here TNMM) and computation of net profit margin in relation to costs incurred, sales effected or assets employed by the enterprise. Precedent treatment: Followed the reasoning of the jurisdictional High Court in Li & Fung India Ltd. (as applied by a coordinate bench in Mitsubishi Corp. India Pvt. Ltd.) that TNMM requires reference to costs actually incurred by the enterprise, not costs of third parties or AEs. Interpretation and reasoning: The factual matrix shows the taxpayer's functions are limited to searching suppliers, obtaining offers, quality checks, logistics coordination, and submitting information to the AE. The taxpayer lacks authority to negotiate, conclude purchase contracts, make strategic sourcing decisions, bear inventory or payment obligations, or assume product/market risks. It operates on an assured return revenue model, undertaking minimal/limited risk with routine, low-complexity functions. Ratio vs. Obiter: Ratio. The Court's finding that the taxpayer's functional profile is that of a limited-risk service provider, not a trader, is central to the determination of appropriate cost base and comparables under TNMM. Conclusions: The Tribunal concluded that the Assessing Officer/TPO erred in treating the taxpayer as a trader and in adopting a remuneration model premised on inclusion of FOB value; the taxpayer is entitled to be remunerated as a limited-risk service provider on an assured-return basis. Issue 2 - Permissibility of imputing third-party/AEs' costs (FOB value) under TNMM/Rule 10B(1)(e) Legal framework: Rule 10B(1)(e) contemplates computation of net profit margin 'in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise' whose ALP is being determined; TNMM compares net profit margin of the tested party to that of comparables based on the tested party's own cost/sales/assets. Precedent treatment: Applied and followed the authoritative reasoning of the jurisdictional High Court (Li & Fung) and the Tribunal's own prior decision (Mitsubishi), which hold it impermissible to include costs not borne by the tested enterprise (such as manufacture/export costs of third-party vendors or FOB values) in the tested party's cost base for TNMM. Interpretation and reasoning: The TPO's approach of enhancing the taxpayer's cost base by including FOB value of goods procured (amounting to Rs. 22,60,34,01,600/-) fundamentally departs from the textual mandate of Rule 10B(1)(e), which requires reference to the enterprise's own costs. Imputing such third-party costs produces a reconstructed financial statement and hypothetical trading profits not reflective of the taxpayer's actual operations or risks, leading to arbitrary and legally unsustainable adjustments. Ratio vs. Obiter: Ratio. The Tribunal treats the holding that third-party/AEs' costs cannot be imputed to the tested party under TNMM as a determinative legal proposition applicable to the adjustment in issue. Conclusions: The Tribunal held that including the FOB value in the taxpayer's cost base was impermissible under TNMM and Rule 10B(1)(e); the TPO's resulting addition of Rs. 43,01,97,828/- is set aside and deleted. Issue 3 - Appropriateness of trading comparables for a limited-risk service provider Legal framework: Transfer pricing comparability requires selection of companies whose functions, assets and risks are comparable to the tested party; TNMM comparisons must be on comparable operational profiles and relevant profit level indicators. Precedent treatment: The Tribunal relied on established jurisprudence that rejects reconstruction of the tested party's profit by imputing trading activities/costs and then applying trading comparables when the tested party does not bear those functions/risks. Interpretation and reasoning: The TPO selected trader entities (e.g., several retail/trading companies) as comparables because of the assumption that the taxpayer's remuneration should be a percentage of FOB value. Given the taxpayer's lack of purchase/stock/market/pricing/credit risk and absence of trading functions, such comparables are functionally dissimilar. Use of trading comparables coupled with an enhanced cost base therefore produced an inappropriate median margin (5.97%) applied to an incorrect cost base. Ratio vs. Obiter: Ratio as to this appeal. The Court's determination that trading comparables were improperly selected because of a flawed functional premise is dispositive of the adjustment upheld by the TPO/DRP. Conclusions: Selection of trading companies as comparables was erroneous; comparability analysis must reflect the taxpayer's limited-risk service-provider profile and use profit indicators based on the taxpayer's own costs/operations. Cross-references and interplay between issues The three issues are interlinked: the mischaracterization of the taxpayer (Issue 1) led to the impermissible inclusion of third-party/AEs' costs (Issue 2) and the consequent selection of trading comparables (Issue 3). The Tribunal treated the characterization and Rule 10B textual requirement as controlling, and relied on jurisdictional precedent to invalidate the composite adjustment. Disposition / Conclusion On the combined grounds above and following binding jurisdictional precedent, the Tribunal set aside the transfer pricing adjustment premised on inclusion of FOB value and selection of trading comparables, directed deletion of the addition of Rs. 43,01,97,828/-, and allowed the appeal.