TaxTMI 
TaxTMI 
2014 (1) TMI 501
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....d (TNMM). The following questions of law arise from the appeal: a. Whether the assessment of the Revenue of arm's length price applying the TNMM method was contrary to the transfer pricing provisions under the IT Act and Rules? b. Whether the Transfer Pricing Officer's (TPO's) apportionment by considering the cost plus mark up of 5% on FOB value of goods between third party enterprises, sourced through the appellant is in compliance with the law? 2. The facts that give rise to these questions of law are as follows. LFIL is a wholly owned subsidiary of Li & Fung (South Asia) Ltd., a company incorporated in Mauritius as a captive offshore sourcing provider. Li & Fung (Trading)(the AE),is a group company incorporated in Hong Kong, which enters into contracts with customers viz. retail chains overseas, for rendering sourcing support services for the supply of high volume, time sensitive consumer goods. The appellant entered into an agreement dated 4.12.1997 with the AE, whereby the contract for rendering sourcing services is outsourced or subcontracted to LFIL, for which it is remunerated at cost plus a mark up of 5% for services rendered to the AE, and ultimately,....
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....ther technical capacity or manpower to assist LFIL and that in the absence of any credible evidence, the involvement of the AE could not be accepted; c) LFIL had developed several unique intangibles which had given an advantage to the AE in the form of low cost of the product, quality of the product and enhanced the profitability of the AE, though the cost for development and use of intangibles was not taken for computation of routine mark up of 5% considered by LFIL; d) LFIL had crucially developed supply chain management which provided the link between the suppliers and customer to achieve strategic and pricing advantage; e) LFIL owned human capital intangible, developed at their own cost with all related risks in creation and maintenance of such intangible; f) the AE recognised that India offers both cost and operational advantage such as lower salaries for the employees, low cost material and low cost manufacture. LFIL had neither quantified this locational saving nor had the AE attributed any part of the additional profit on account of locational saving to LFIL. 7. The TPO did not, as stated earlier, dispute the analysis undertaken by LFI....
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.... nor has attributed any part of the additional profit on account of locational saving to the assessee, in India. It is pertinent to mention here that the assessee is the most critical part of global supply chain of the AE. It is responsible for identifying and qualifying the contracted manufacturer, for working with them and other designers to manufacture garments in the technical specifications, for selection of fabrics, for control over the manufacturer, for identifying appropriate sourcing of fabrics and accessories, for quality insurance, for transportation logistics and for coordinating logistics. The compensation model for the assessee which is based on reimbursement of the cost with the percentage mark up has not included locational saving attributable to the assessee. These facts prove that cost plus compensation @ 5% of cost of the assessee is not at arm's length because it does not include profit attributable to the assessee on account of locational saving. 5.3 Whether the assessed commission should be expressed as a percentage of the FOB price of goods sourced through the assessee? In this case the AB has allowed commission of 5% of cost incurred by the....
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....on of FOB cost of goods sourced from India. 6. The risk profile of the assessee has been discussed in detail in Para 5.2.1 of this order. It has been discussed in detail in this order that the assessee functions like an independent entrepreneur. Hence, it takes matching risks. For sake of convenience, risks relevant in the business of the assessee and risks disclosed in T.P. studies are analyzed in the following table:- SI. No. Risk matrix relevant to business of the assessee The risk matrix as disclosed in transfer pricing report under Rule 10D 1 Market Risk Disclosed in transfer pricing report 2 Service liability Disclosed in transfer pricing report 3 Capacity utilization risk Disclosed in transfer pricing report 4 Foreign exchange risk Disclosed in transfer pricing report 5 Credit & collection risk Disclosed in transfer pricing report 6 Scheduling risk Not disclosed in transfer pricing report but actually borne by assessee. 7 Government & institutional risk Not disclosed in transfer pricing report but actually borne by assessee. 8 Operational risk Not disclosed in transfer pricing report bu....
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....14 comes to 5.22%. This is in consonance with the assessee's claim it is operating on cost plus 5% markup basis. Following the discussion in the preceding paras, the receipt as claimed by the assessee, shall be substituted by the FOB value of exports being Rs.1202.96 crores. The markup of 5% that shall be applied to this and the same shall be credited to the Profit & Loss Account. After taking into account this gross income, the net operating income is computed at Rs.601,480,000. Thus, the arm's length price is calculated as below: Net Operating income (as calculated above) Rs.601,480,000 Operating income shown by assessee Rs.24,918,814 Difference Rs.576,561,186 Accordingly, the value of the international transaction of the assessee shall be adjusted upward by Rs.576,561,186 to bring it to arm's length. Since the difference computed as a percentage of the Arm's Length Price is more than 5% no benefits under the proviso to Section 92C(2) is available to the assessee. 10. The transfer pricing approach may be summarized as below. (i) The assessee has used TNMM as the method and OP/TC was claimed to be the PLI. (ii) It was noticed t....
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....rangements of a specific nature that are not or are very rarely encountered between independent parties. This may be done for various economic, legal, or fiscal reasons dependent on the circumstances in the particular case. Moreover, contracts within an MNE could be quite easily altered, suspended, extended, or terminated according to the overall strategies of the MNE as a whole, and such alterations may even be made retroactively. In such instances, tax administrations would have to determine what the underlying reality is behind a contractual arrangement in applying the arm's length principle. 1.68 In addition, tax administrations may find it useful to refer to alternatively structured transactions between independent enterprises to determine whether the controlled transaction as structured satisfied the arm's length principle. Whether evidence from a particular alternative can be considered will depend on the facts and circumstances of the particular case, including the number and accuracy of the adjustments necessary to account for differences between the controlled transaction and the alternative and the quality of any other evidence that may be available." T....
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....s remunerated by third parties based on such services, the Tribunal relied upon the mark up on FOB value of goods sourced through LFIL as the appropriate method to work out arm's length compensation. The tribunal accepted the TPO's reasoning for applying the 5% of the FOB value of exports to third parties by Indian manufacturers. The relevant part of the reasoning in the impugned order is reproduced below: "The TPO did not consider the cost plus compensation @ 5% at arms length by holding that assessee is performing all critical functions, assuming significant risks and used both tangibles and unique intangibles developed by it over a period of time. The associated enterprise is not having technical capacity and manpower to assist the assessee in this regard. The assessee has developed several unique intangibles which has been given advantage in the form of low cost of product, quality of the product and enhanced the profitability of AE. These intangibles have developed profit potential of AE. The assessee has developed the supply chain management which gives customer a strategic and pricing advantage. The assessee has also developed its own human capital intangible at its....
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....ith the help of tangible and unique intangibles developed over the years and with the help of supply chain management which are important to achieve the strategic and pricing advantage. All these help the associated enterprise to enhance and retain the business and also contributes towards the locational savings on account of low cost salary, low cost material and low cost manufacture in India. Therefore, in our considered view, the cost plus 5% mark up is definitely not on the arms length while working out the compensation for the services rendered by the assessee to the associated enterprise. In such a situation, mark up on the FOB value of the goods sourced through the assessee shall be the most appropriate method to work out the correct compensation at arms length price. Therefore, the rules of consistency cannot be applied forever when such facts have not been considered/discussed at all in the earlier years. It is also pleaded that the assessee has received 80-O deduction in the earlier years in respect of providing these professional and technical services. In this regard, we hold that every assessment year is a separate assessment year for incometax purposes and th....
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....intangibles to perform all the critical functions. These tangible and unique intangible have been developed over the years. In view of these facts, we hold that to arrive at arm's length of these transactions, the mark up must be on the basis of FOB (free on board) value of the exports. Since the AE is receiving 5% of FOB value then the total receipt by AE must be Rs.60.148 crores. Thus, the attribution between assessee and AE must be from this amount. AO made addition of Rs.33.60 crores. If it is added to the actual receipts of assessee then it is much more than the total amount received by associated enterprise regard to these exports. Thus, the way in which this adjustment has been made gives abnormal / absurd results which cannot be sustained. The assessee was performing critical functions with the help of tangible and unique intangibles developed over the period of time and with the help of supply chain management which the assessee had developed, the majority of compensation based on the FOB value of the exports materialized through the assessee must come to the assessee. So the correct compensation at the arms length price based on the FOB cost of the goods sourced ....
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....ng services is not sustainable for the reason that the TPO applied the TNMM method contrary to the Transfer Pricing Regulations. Section 92 of the Act stipulates that any income arising from an international transaction shall be computed having regard to the arm's length price. Further, Section 92F(ii) defines arm's length price as a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises in uncontrolled conditions. For the purpose of determining the arm's length price in relation to an international transaction, various methods are prescribed under section 92C(2) of the Act and Rule 10B of the Rules provide the manner in which such methods should be applied by the assessee, assessing officer, Transfer Pricing Officer, etc. 11. Mr. Porus Kaka, learned senior counsel, while stating that the TNMM was chosen by LFIL as the appropriate method to calculate the arm's length, provided the court with an interpretation of the provision. He argued that for applying TNMM, it would be noted that the net profit margin realized from the international transactions by the appellant is to be computed only with reference to the cost incu....
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....cilitated by the assessee would lead to an arbitrary adjustment to the income of the appellant which was never intended by the legislation. 16. The learned counsel further contended that LFIL is performing such functions which undertake a limited risk, and do not involve the direct manufacture of goods. This is evident from the fact that LFIL has made no investment in the plant, inventory, working capital, inter alia nor does it bear any enterprise risk for manufacture and export of the goods. Thus, LFIL's functional and risk profile is entirely different and has nothing to do with manufacture and export of consumer goods by unrelated third parties. Counsel argued that LFIL was merely involved in rendering buying or sourcing support services with regard to such goods and received a handsome remuneration on a cost plus mark-up of 5% which adequately highlights the functions performed, assets utilized and risks borne by the appellant on application of TNMM. 17. It was next urged that the said method of assessment undertaken for determining the arm's length price of international transactions applying TNMM was accepted in the Transfer Pricing assessment consistently year after y....
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.... the contract with the unrelated party customers for rendering buying services at 4% to 5% of FOB value of exports. The appellant has in turn received services fee (at cost +5%) of Rs. 47.69 crores which is nearly 4% of the FOB value of the export from the AE. However, the TPO/AO in the impugned order has computed the arm's length price of the appellant by considering a mark-up of 3% on the FOB value of exports that have been facilitated by the appellant computed an adjustment of Rs 33, 59, 69, 186/-. 20. The counsel argued that the adjustment made by the TPO/AO would result in LFILF, which is only a subsidiary, ended up receiving higher amount than what has been received by the AE from third party customers in lieu of facilitating the export of finished goods. This can be noted from the fact that such adjustment proposed by the TPO/AO has resulted in the AE retaining only 1% of the FOB value of export on the entire export of Rs 1202.96 crores, with nearly 80% of the remaining consideration on FOB value of export must be borne by LFIL. The counsel for the appellant argued that since substantial functions relating to the buying services, undertaking enterprise risks, utilization ....
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....s of lower authorities were to be sustained. 23. It was lastly argued that OECD also visualizes that AEs can structure their transactions in such manner as may require close scrutiny. The TPO's task is therefore to often look behind the facts as they seem and arrive at the substance of the transaction to compute the value of the transaction. The application of the cost plus (TNMM) method by basing the return on the FOB value therefore afforded a realistic picture. If this were not the case, learned counsel submitted that income generated by LFIL's services, but credited to the AE, would fall outside the tax net, contrary to the purpose of the transfer pricing provisions. Moreover, it was argued that if such services were directly provided by LFIL, without the AE acting as an intermediary, the payment for its services would far exceed the payment it is received from the AE, which is a crucial indicator that the transaction, as it currently stands, is not at arm's length and requires interference. Thus, it was argued by learned counsel that determination of ALP and real income was sound and did not call for interference. Discussion regarding the relevant provisions of the IT Ac....
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.... on between the resident and a non-resident, if it appeared to the Assessing Officer that owing to the close connection between them, the course of business was so arranged so s to produce less than expected profits to the resident. Rule 11 prescribed under the section provided a method of estimation of reasonable profits in such cases. However, this provision was of a general nature and limited in scope. It did not allow adjustment of income in the case of non- residents. It referred to a ?close connection? which was undefined and vague. It provided for adjustment of profits rather than adjustment of prices, and the rule prescribed for estimating profits was not scientific. It also did not apply to individual transactions such as payment of royalty, etc., which are not part of a regular business carried on between a resident and a non-resident. There were also no detailed rules prescribing the documentation required to be maintained. 55.3 With a view to provide a detailed statutory framework which can lead to computation of reasonable, fair and equitable profits and tax in India, in the case of such multi-national enterprises, the Act has substituted section 92 with a new....
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....t margin method and; (f) such other method as may be prescribed by the Board. In determining the most appropriate method, regard is to be had to Rules 10A and 10B of the IT Rules, 1962. Section92C(3) casts the obligation of computing the ALP on the assessee, at the first instance. The AO then would proceed to determine the ALP in relation to an "international transaction" in accordance with Section 92C (1) and (2) only if he is of the opinion that any of the circumstances as indicated in Section 92Cs (3)(a) to sub-clause (d) of sub-Section (3) of Section 92C prevails. These circumstances are that the price charged or paid for international transaction has not been determined as prescribed under sub- section (1) and (2) of section 92C or, the assessee has not kept information and documents of its international transactions in the form prescribed under Section 92D (1) and the Rules made in that regard or, the information or data used by the assessee in computing the ALP is not reliable or correct or, that the assessee, failed to furnish, within the specified time the information sought pursuant to a notice issued under Section 92D (3). The first proviso to Section 92 (3) mandates tha....
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....mmercial or financial relations which differ from those which would have been made between independent enterprises, then any profits which would, but for those conditions, have so accrued, may be included in the profits to bring them to a level that would prevail when independent enterprises would enter into comparable transactions under comparable conditions. Section 92F(ii) specifically defines Arm's Length Price as a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises in uncontrolled conditions. 31. To compute arm's length price of an assessee, several methods are prescribed under Section 92C of IT Act. As per this provision, the arm's length price in relation to an international transaction shall be determined by the "most appropriate method" out of the prescribed methods i.e. a) comparable uncontrolled price method; b) resale price method; c) cost plus method; d) transactional net margin method; e) profit split method and f) any method as prescribed by the Revenue. In case where more than one price can be determined by the most appropriate method, the arm's length price calculated is the arithmetic mea....
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....ding a comparable transaction. In addition, a functional analysis of both the associated enterprise and the independent enterprise is required to determine if the transactions are comparable. It might of course be possible to adjust results for minor functional differences, provided that there is sufficient comparability to begin with, The standard of comparability for application of TNMM is no less than that for the application of any other transfer pricing method. 35. The ITS 2009 Transfer Pricing Guidelines accepted by the OECD state, inter alia, that when an associated enterprise acts only as an agent or intermediary in the provision of the service, it is important in applying the cost plus method that, in the ultimate analysis, the return or mark-up is appropriate for the performance of the agency function rather than for the performance of services themselves. Rule 3.41 of the Transfer Pricing Guidelines 2009 state that in applying the TNMM, various considerations should influence the choice of margin used. These include the reliability of the value of assets employed in the calculations is measured and the factors affecting whether specific costs should be passed through,....
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.... enterprise and mark up on the FOB value of the goods sourced through the assessee shall be the most appropriate method for calculation of arm's length price. 38. In scrutinizing Transfer Pricing documents, the TPO undertakes an exercise known as "FAR" (functions performed, assets owned and risks assumed by the associated enterprises involved). This analysis plays a critical role in determining the arm's length price of an international transaction entered into between AEs. The FAR analysis defines roles, responsibilities and risks assumed by the parties involved providing steadfast pointers into the underlying economic substance of the transactions. The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations too recognize the importance of FAR in the transfer pricing context, with the arm's length compensation between AEs reflecting the functions that each enterprise performs (taking into account the assets used and the risks assumed by either party).In this case, what prevailed with the TPO and all other authorities was the circumstance that LFI, i.e. the assessee, according to them, performed all the critical functions, assumed significant risks....
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....ed by the TNMM under Rule 10B(1)(e) of the Rules. Having determined that (TNMM) to be the most appropriate method, the only rules and norms prescribed in that regard could have been applied to determine whether the exercise indicated by the assessee yielded an ALP. The approach of the TPO and the tax authorities in essence imputes notional adjustment/income in the assessee's hands on the basis of a fixed percentage of the free on board value of export made by unrelated party venders. 41. LFIL, in the Transfer Pricing documentation, established the international transactions of rendering buying services to be at the arm's length price having regard to the operating profit margin of comparable companies having similar functional profile. LFIL's computation of the operating profit margin (OP/TC per cent) by enhancing the cost base, i.e., by increasing the cost of the sales facilitated by LFIL leads to an arbitrary adjustment of its income, as such an alteration resides plainly outside the Rules and the provisions of the Act. 42. Moreover, there is considerable merit in the submission that the (finding of the) lower authorities, including the Tribunal, misdirected themselves ....
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.... party vendor/customers. Rather, it is the AE that undertakes substantial functions and in fact assumes enterprise risks, such as market risk, credit risk etc. It also bears the letter of credit associated charges and other expenses. 44. Another important aspect which cannot be overlooked is that the the transfer pricing documentation maintained in terms of section 92D of the Act read with rule 10B of the Income-tax Rules, determined the arm's length price of the "international transaction" of the provision of buying services applying the TNMM, by comparing operating profit margin of LFIL with that of the comparable companies, as under:- Weighted average OP/OC per cent. Of 26 comparable companies 4.07 per cent. OP/OC per cent. of LFIL 5.17 er cent. This exercise has not been discarded. In other words, the TPO and the appellate fora were aware that in accordance with the rules, a comparison of the profit margin of LFIL with that of other similarly functioning companies was shown, and is, at the first instance, relevant to determine the ALP. The profit margin, as well as the cost plus model adopted by LFIL, was not shown to be distorted or of such magnitude as t....
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....tors: Circular No. 12 dated 23rd August, 2001 reads as follows: "The aforesaid provisions have been enacted with a view to provide a statutory framework which can lead to computation of reasonable, fair and equitable profit and tax in India so that the profits chargeable to tax in India do not get diverted elsewhere by altering the prices charged and paid in intra-group transactions leading to erosion of our tax revenues. ................. ....................... (iii) it should be made clear to the concerned Assessing officer s that where an international transaction has been put to a scrutiny, the Assessing officer can have recourse to Sub-section (3) of section 92C only under the circumstances enumerated in Clauses (a) to (d) of that sub-section and in the event of material information or documents in his possession on the basis of which an opinion can be formed that any such circumstance exists. In all other cases, the value of the international transaction should be accepted without further scrutiny." The following portions of Circular No. 14 are relevant: "The relevant portions of Circular No. 12 may be usefully referred to as u....
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....price and pass a speaking order after obtaining the approval of the Department of Income Tax (Transfer Pricing). The order should contain details of data used, reasons for arriving at a certain price and applicability of methods, subject to judicial scrutiny. The order of the TPO, in the instant case, has not provided any substantive reasons for disregarding the TNM method as applied by LFIL. Further, the TPO's arbitrary exercise of adjusting the cost plus mark up of 5% on the FOB value of exports finds no mention in the IT Act nor the Rules. Such an exercise of discretion by the TPO, disregarding the LFIL's lawful tax planning measures with its group companies, is not in compliance with the IT Act and Rules of Income Tax. 49. This court summarizes its conclusions as follows: (a) The broad basing of the profit determining denominator as the entire FOB value of the contracts entered into by the AE to determine the LFIL's ALP, as an "adjustment", is contrary to provisions of the Act and Rules; (b) The impugned order has not shown how, and to what extent, LIFIL bears "significant" risks, or that the AE enjoys such locational advantages, as to warrant rejection of ....