ITAT Mumbai allows assessee appeal on transfer pricing, rules functional similarity over product similarity in RPM comparability analysis

ITAT Mumbai ruled in favor of the assessee in a transfer pricing dispute involving international transactions with its Thai AE. The tribunal held that under the Resale Price Method (RPM), functional similarity takes precedence over product similarity in comparability analysis. The court directed the TPO/AO to include five rejected chemical trading companies as valid comparables, finding that operational comparability matters more than product differentiation for benchmarking purposes. The assessee's appeal was allowed, with the tribunal concluding these companies were appropriate comparables for determining arm's length pricing.

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The primary legal issue considered in this appeal pertains to the Transfer Pricing Adjustment under the Income Tax Act, 1961, specifically the determination of the Arm's Length Price (ALP) for international transactions entered into by the assessee with its Associated Enterprise (AE) for the assessment year 2021-22. The core questions examined include:

• Whether the Transfer Pricing Officer's (TPO) exclusion of certain comparable companies engaged in bulk chemical trading, as opposed to specialty chemical trading by the assessee, was justified for benchmarking under the Resale Price Method (RPM).
• The relevance and necessity of product similarity versus functional and operational comparability in selecting comparable companies for transfer pricing benchmarking under RPM.
• Whether the addition of Rs. 2,39,98,806/- to the assessee's income on account of transfer pricing adjustment is sustainable in law and on facts.
• Whether the use of extraneous evidence such as Google website graphs or reliance on surmises and conjectures by the Assessing Officer (AO) and Dispute Resolution Panel (DRP) was appropriate.
• Whether the principles of natural justice were complied with, particularly regarding the opportunity for personal hearing before confirming the addition.

Issue-wise Detailed Analysis

1. Validity of Exclusion of Bulk Chemical Traders as Comparables

Legal Framework and Precedents: The Transfer Pricing provisions under sections 92 to 92F of the Income Tax Act, 1961, require that international transactions between associated enterprises be benchmarked at arm's length price. Rule 10B(1)(b) prescribes the Resale Price Method (RPM) as one of the methods to determine ALP, which involves comparing gross profit margins earned by the tested party with those earned in comparable uncontrolled transactions involving the same or similar property or services.

Relevant precedents include the Tribunal's decision in Mattel Toys (I) (P) Ltd. vs. DCIT, which held that under RPM, product similarity is not a strict requirement; rather, operational and functional comparability are paramount. Other coordinate bench decisions such as ACIT vs. Kobelco Construction Equipment India Ltd. and Pepperl & Fuchs (India) (P.) Ltd. reinforce this principle.

Court's Interpretation and Reasoning: The Tribunal emphasized that RPM focuses on gross profit margins and the functions and risks undertaken by the tested party rather than strict product similarity. The Tribunal noted that the TPO excluded 13 companies on the ground that they traded in bulk chemicals, unlike the assessee who traded in specialty chemicals. However, the Tribunal found that the TPO and DRP's reliance on product differentiation overlooked the established legal position that operational comparability supersedes product similarity under RPM.

Key Evidence and Findings: The assessee submitted that five companies engaged in trading chemicals similar in nature and function to the assessee's business should be included as comparables. The Tribunal examined the business profiles and annual reports of these five companies-A-One Chem-Trade Pvt. Ltd., CHD Chemicals Ltd., Prakash Chemicals Agencies Pvt. Ltd., Siskaa Chemicals Ltd., and Yash Chemex Ltd.-and found that they were engaged in chemical trading for industries such as textiles, paints, and dyes, closely resembling the assessee's operations.

Application of Law to Facts: Applying the principles laid down in the precedents, the Tribunal held that these five companies are functionally comparable to the assessee. Since the RPM method benchmarks gross margins and the functional profile of the companies is similar, exclusion based solely on product category (bulk vs. specialty chemicals) was unwarranted.

Treatment of Competing Arguments: The Revenue argued that specialty chemicals and bulk chemicals differ significantly in production volume, market dynamics, customer base, and profit margins, thus making bulk chemical traders non-comparable. The Tribunal rejected this argument, reiterating that the functional and operational comparability, not product differentiation, is the key factor under RPM.

Conclusion: The Tribunal directed the inclusion of the five specified companies as comparables for benchmarking the international transactions, thereby reducing the transfer pricing adjustment.

2. Relevance of Product Similarity in RPM Benchmarking

Legal Framework and Precedents: Rule 10B(1)(b) of the Income Tax Rules, 1962, prescribes RPM and requires comparison of gross profit margins from purchase and resale of the "same or similar" property or services. The Tribunal in Mattel Toys (I) (P) Ltd. clarified that "same or similar" does not necessitate strict product similarity but extends to operational comparability.

Court's Interpretation and Reasoning: The Tribunal emphasized that RPM focuses on the gross profit margin as a measure of compensation for functions performed and risks borne. The nature of the product does not materially affect the gross profit margin, which reflects the operational aspects of the business. Therefore, the functional attributes and risk profiles of the companies are the primary criteria for comparability, not the exact product category.

Key Evidence and Findings: The Tribunal relied on the Transfer Pricing Study Report and the functional profiles of the assessee and comparables, noting that the assessee performed functions such as strategic planning, procurement, warehousing, marketing, inventory management, and sales distribution without value addition or significant risk assumption.

Application of Law to Facts: Given the similarity in functions and risk profiles between the assessee and the five chemical trading companies, the Tribunal found that product similarity was not a decisive factor under RPM.

Treatment of Competing Arguments: The Revenue's insistence on strict product similarity was held to be inconsistent with the statutory provisions and judicial precedents.

Conclusion: The Tribunal reaffirmed that under RPM, operational comparability is the key, and product similarity is not a vital aspect for comparability analysis.

3. Legitimacy of Transfer Pricing Adjustment and Addition of Rs. 2,39,98,806/-

Legal Framework and Precedents: Section 92CA(3) of the Act empowers the TPO to determine ALP and make adjustments if the declared price is not at arm's length. The AO and DRP's role is to confirm or modify the TPO's determination under sections 143(3), 144C(5), and 144C(13).

Court's Interpretation and Reasoning: The Tribunal found that the TPO's adjustment was based on excluding comparables that were not functionally similar. Since the Tribunal ordered inclusion of five additional comparable companies, the arm's length margin and resultant adjustment would be recalculated accordingly.

Key Evidence and Findings: The assessee's declared gross margin was 4.58%, while the TPO's comparables yielded a higher median gross margin of 6.91%. Inclusion of the five additional companies would bring the assessee's margin within the arm's length range.

Application of Law to Facts: The Tribunal's direction to include the additional comparables implies that the original adjustment is not sustainable in its entirety and must be revised.

Treatment of Competing Arguments: The Revenue maintained the adjustment was justified based on the comparables selected by the TPO and DRP. The Tribunal disagreed, emphasizing adherence to correct comparability principles.

Conclusion: The addition of Rs. 2,39,98,806/- is not upheld as is; the matter is remanded for recalculation after including the five companies as comparables.

4. Use of Extraneous Evidence and Evidentiary Value of Google Graphs

The assessee challenged the use of Google website graphs and similar suggestive figures relied upon by the AO/DRP, citing judicial pronouncements that such evidence lacks evidentiary value. The Tribunal did not expressly delve into this issue in detail but implicitly rejected such reliance by focusing on the Transfer Pricing Study Report and statutory comparability criteria.

5. Compliance with Principles of Natural Justice and Personal Hearing

The assessee contended that the AO/DRP confirmed the addition without providing proper personal hearing, violating principles of natural justice and contrary to the CBDT circular prescribing mandatory conditions for personal hearing. The Tribunal did not address this issue explicitly in its order, leaving it open.

Significant Holdings

"The RPM is mostly applied in a situation in which the reseller purchases tangible property or obtain services from an A.E. and reseller does not physically alter the tangible goods and services or use any intangible assets to add substantial value to the property or services i.e., resale is made without any value addition having been made. Since in RPM only margins are seen with reference to items purchased and sold or earned by an independent enterprise in comparable uncontrolled transactions vis-a-vis the one in the controlled transactions, therefore, in such a situation, the nature of products has not much relevance though their closer comparable may produce a better result. The focus is more on same or similar nature of properties or services rather than similarity of products. In RPM other attributes of comparabilities than the product itself can produce a reliable measure of arm's length conditions."

Core principles established include:

• Under RPM, functional and operational comparability is paramount; strict product similarity is not essential for transfer pricing benchmarking.
• The selection of comparable companies must be based on similarity of functions performed and risks assumed rather than solely on product categories.
• Transfer pricing adjustments must be based on an accurate and comprehensive comparability analysis; exclusion of relevant comparables without valid functional justification is impermissible.

Final determinations:

• The five additional chemical trading companies submitted by the assessee are valid comparables and must be included in the benchmarking analysis.
• The impugned transfer pricing adjustment of Rs. 2,39,98,806/- is set aside and the matter remanded for fresh computation incorporating the additional comparables.
• Other issues raised by the assessee, including reliance on extraneous evidence and natural justice concerns, are left open for future adjudication.

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