Royalty Adjustment Disallowed When TNMM Accepted for Manufacturing Segment; TPO Cannot Separately Benchmark Technical Fee u/s 92C

ITAT Delhi (AT) held that once the Transfer Pricing Officer (TPO) accepted the combined benchmarking under TNMM for the manufacturing segment, with the Profit Level Indicator already incorporating payment of royalty, a separate arm's length adjustment for the royalty transaction was impermissible. The TPO had determined the assessee's entry-level operating margin of 4.19% as at arm's length while giving effect to DRP directions. ITAT ruled that, having accepted TNMM as the most appropriate method, the TPO could not isolate and re-benchmark only the royalty/technical fee element under a different method. The assessee's appeal was accordingly allowed.

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1. ISSUES PRESENTED AND CONSIDERED

1.1 Whether, after acceptance of the combined benchmarking under TNMM for the manufacturing segment (with royalty treated as an operating expense), a separate transfer pricing adjustment can be made in respect of the international transaction of payment of royalty by applying a different method (CUP).

2. ISSUE-WISE DETAILED ANALYSIS

Issue 1: Separate TP adjustment on royalty despite acceptance of combined TNMM benchmarking

Legal framework (as discussed)

2.1 The assessment involved benchmarking of multiple international transactions using the Transactional Net Margin Method (TNMM) on an aggregate basis, with the profit level indicator (PLI) being operating profit to operating revenue. Payment of royalty was included as an operating expense in determining the entity-level operating margin. The Transfer Pricing Officer (TPO) initially made an adjustment on manufacturing operations and also separately benchmarked the royalty transaction under the Comparable Uncontrolled Price (CUP) method. Pursuant to the Dispute Resolution Panel's directions, the TPO accepted the assessee's operating margin of 4.19% as being within the arm's length range for the manufacturing segment and deleted the TP adjustment in respect of manufacturing, but retained a separate adjustment on royalty under CUP.

Interpretation and reasoning

2.2 The Court noted that the TPO, in the order giving effect to the Dispute Resolution Panel's directions, categorically accepted that the assessee's operating margin of 4.19% falls within the arm's length range of comparables and reduced the earlier adjustment on manufacturing to nil. It was undisputed that this 4.19% operating margin had been computed after treating royalty as part of operating costs.

2.3 On these facts, the Court held that once a combined benchmarking approach under TNMM is accepted for the manufacturing activity, and the PLI (operating margin) that has been accepted as arm's length already embeds the royalty payment as an operating expense, then the same royalty transaction cannot be subjected to a separate benchmarking and adjustment.

2.4 The Court relied on the ratio of the jurisdictional High Court in Magneti Marelli Powertrain India Private Ltd. v. DCIT, wherein it was held that, having accepted TNMM as the most appropriate method in respect of all international transactions (including the impugned item), it is not open to the TPO to carve out a single element and benchmark it separately under a different method (CUP). Each method is a complete package of filters and standards for arm's length determination, and mixing methods within the same set of transactions for the same year would distort the arm's length price determination and create inconsistency and uncertainty.

2.5 The Court observed that the same principle applies where the TPO has accepted the assessee's entity-level operating margin (including royalty) as arm's length under TNMM: to then separately apply CUP only to royalty would offend the accepted combined approach and effectively lead to multiple methods being applied to interlinked transactions already benchmarked together.

2.6 The Court also noted that similar principles have been affirmed in other judicial precedents cited, and treated those as supporting the proposition that once aggregation under TNMM is accepted and found at arm's length, a separate royalty adjustment is unwarranted.

Conclusions

2.7 The Court held that, in the circumstances where the TPO has accepted the combined TNMM benchmarking and the entity-level operating margin of 4.19% (computed after including royalty as an operating expense) as being at arm's length, a separate transfer pricing adjustment for the royalty transaction is impermissible.

2.8 The separate adjustment made on account of payment of royalty was deleted, and the assessee's appeal was allowed. Grounds relating to alternative benchmarking of royalty (selection/rejection of comparables and effective royalty rate) did not require adjudication in view of this conclusion.

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